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Principles of 
Economics 



Fr'^^Mr TAYLOR, Ph.D. 

Professor of Economics in the 
University of Michigan 




NEW YORK 

THE RONALD PRESS COMPANY 
1921 




\ 



Copyright, 192 1, by 
The Ronald Press Company 



All Rights Reserved 



JUL 12 "2 

©aA617637 



i 



PREFACE 

It is hardly necessary to say that this book is intended only for 
use as a textbook. There is perhaps more need to explain that it 
does not cover quite the same ground as the conventional type of 
such books. First, it contains less descriptive matter than is com- 
monly offered. As this perhaps assumes more knowledge of eco- 
nomic phenomena than the average student in elementary economics 
possesses, it may' be desirable to use along with this text, especially 
in the early stages of the course, some book on economic organization. 
At Ann Arbor we have been trying this plan during the current 
semester and expect to continue doing so next year. 

But this book not only starts at a point somewhat later than 
the conventional textbook, it also stops at an earlier point. More 
specifically it stops short of any serious study of practical problems 
such as the Tarifif, Business Cycles, and Labor Legislation. In so 
far as such problems receive any comment at all, this occurs in the 
process of illustrating economic principles, — no attempt being made 
to pass judgment on such problems taken as a whole. In short, this 
book is not intended to be a general treatise, the mastery of which 
will give the student a fairly adequate knowledge of the whole 
economic field. Instead, it is intended to perform just one special 
function in the student's economic education, namely, helping him to 
master the body of principles, mostly quite abstract, which are 
generally held by economic authorities. 

I have noted that this textbook is designed to perform a nar- 
rower function than is usually undertaken by such books. It may 
be well to add that it also differs from most others in that it lays 
more stress on securing for the student a very definite mastery of 
the accepted body of economic principles, — such mastery as the 
student of Chemistry or Physics is expected to acquire. This will 
explain the rather rigid methods of statement, the presentation of 



IV PREFACE 

principles in formal shape, and the extensive use of problems or 
examples which the student is expected to work out. 

In view of the air of finality given by the method of presenta- 
tion just remarked upon, it seems almost necessary to explain that 
this book has no real finality in the mind or purpose of the author. 
In fact, it is only a book in the making. It has been revised almost 
every year since it was first brought out in a series of separate 
leaflets fifteen or sixteen years ago; and the contract with the pres- 
ent publisher provides for a continuation of that policy. This does 
not mean that the author considers such a procedure requisite in 
order to keep up with fundamental changes in economic doctrine, 
but merely that, in working out his plan, he seems to find it neces- 
sary to resort to the method of trial and error. Each edition, 
therefore, contains experiments in analysis and presentation which 
are expected to show a need for revision and to get such revision in 
later editions. The necessity for this procedure is diminishing; but 
it has by no means disappeared. I expect, therefore, to continue the 
policy indicated for some time to come. 

A cursory reading of this book will show that it makes little or 
no claim to originality in substance. Still, it would be quite impos- 
sible that any man who has taught elementary economics for thirty- 
four years and advanced courses in economic theory for twenty-eight 
years, should not secretly cherish the belief that he has made some 
trifling modifications in economic analysis which seem to partake of 
the nature of contributions. However, it is not worth while to give 
these more specific comment. If such modifications are of any 
significance the fair-minded student will note the fact; if not, the 
less said about them the better. 

If it had not already been sufficiently brought out by implication 
in this preface, the reader of the text would very soon learn that 
the body of doctrine herein contained is, on the whole, rather mark- 
edly orthodox. I should have been sorry to be obliged to make it 
otherwise; for I should have been sorry to believe that our prede- 
cessors have left no body of doctrine which is to abide for an 
indefinite period in the future. I have been at some pains, how- 
ever, to stress the point that the acceptance of orthodox economic 
doctrine is entirely compatible with giving support to whatever 



PREFACE V 

degree of interference with the working of the present economic 
order may prove on the whole conducive to the welfare of society. 

It is not my intention to enumerate the particular persons who in 
one way or another have contributed to the preparation of this text, 
chiefly, perhaps, because the list would be too long. In general I feel 
that I owe most to the small army of young men who in the course 
of the last fifteen years have assisted in teaching it at this university. 
From them I have received many useful criticisms and many valu- 
able suggestions. The only person whose hand is largely shown in 
the present form of the book is Mr. Elmer C. Adams — now with the 
Detroit Evening News — who collaborated with me in the preparation 
of the fifth edition. 

The most important change in the present edition is the revised 
treatment of the prices of primary factors presented in Chapters 
XXIX and XXX. Minor ones appear at various points, particularly 
in the introductory chapter and the chapter preliminary to the 
discussion of price. 



Frederick M. Taylor 



Ann Arbor, Michigan 
July 5, 192 1 



CONTENTS 



Chapter Page 

I Introductory i 

II General Survey of the Existing Economic Order i6 

III Authoritative Control in the Existing Economic 

Order 36 

^ IV Analysis of Production „ 46 

V Capital as Capital 59 

VI The Different Agents in Production .... 81 

VII General Conditions of Productive Efficiency . 89 

VIII Efficiency of Different Factors 105 

IX Increase in Output and Rate of Production . . 122 

X Attempts to Increase Output and Some Economic 

Consequences 136 

XI Increase in Output and Cost of Production . . 146 

XII Money Exchange 160 

XIII Credit Exchange 175 

XIV Some Money Truisms 187 

XV Say's Law 196 

XVI The Principle of Reciprocity . . . . . . 206 

XVII The Law of Comparative Costs 220 

XVIII Speculative Trading and Insurance .... 227 

XIX Value and Prices Preliminary ...... 242 

XX Market Demand Schedules 253 

vii 



Vlll 

Chapter 
XXI 

XXII 

XXIII 

XXIV 

XXV 

XXVI 

XXVII 

XXVIII 

XXIX 

XXX 

XXXI 

XXXII 

XXXIII 

XXXIV 

XXXV 

XXXVI 

XXXVII 

XXXVIII 

XXXIX 

XL 

XLI 

XLII 

XLIII 

XLIV 



CONTENTS 

Page 

Market Supply Schedules 268 

Principles Governing the Immediate Processes of 

Price Determination ........ 278 

Limiting Prices 289 

Normal Demand Schedules . . . . . . 298 

Normal Supply Schedules 311 

Principles Governing the Determination of Nor- 
mal Price . . 326 

Special Cases of Normal Price 342 

The Prices of Primary Factors and Disutility . 357 

The Prices of Primary Factors and Significance . 364 

The Prices of Primary Factors and Significance 

(Continued) 372 

The System of Prices as a Whole . . . . . 382 

Principles Governing the Money Standard . . 393 

Principles Governing the Circulation of Money . 404 

Principles Governing the Movements and Distri- 
bution of Money 413 

Principles Governing the Value of Money . . 425 

The Present System of Distribution .... 438 

The General Principle of Distribution : Corollaries 447 

Rent 456 

Interest . . . . 468 

Wages 481 

Profits 493 

Critique of Existing System : Introductory . . 503 

Critique of Present Principle of Distribution . 511 

The Property Incomes Indestructible .... 524 



CONTENTS ix 

Chapter Page 
XLV The Property Incomes as Incomes of Private 

Owners 530 

XLVI Critique of the Process Whereby Production is 

Regulated . 544 

XLVII Critique of Production in Respect to Efficiency , 554 

XLVIII Critique of Consumption 560 

Appendix — Explanatory Notes 563 



CHAPTER I 

INTRODUCTORY 

Goods. — One of the most characteristic marks of a sentient 
being Hke man is to have wants, — we might almost say that to feel 
wants and secure their satisfaction is the very essence of living. 
Again, it is manifest that the satisfaction of any want depends on 
the presence of the appropriate condition. The satisfaction of phys- 
ical hunger depends on having food at our disposal ; the satisfaction 
of our craving for affection requires a certain attitude on the part of 
some other person or persons ; the satisfaction of our love of beauty 
depends on the presence of beautiful objects ; and so on. All objects 
or conditions on which the satisfying of wants is dependent, we shall 
call goods, using the term very broadly. The property of goods 
whereby they are thus able to satisfy wants we call their utility. 

Economic Goods. — But, now, as students of economics, we 
are concerned, not with every kind of goods, but only with one par- 
ticular kind known as economic goods. Our next duty, therefore, 
is to learn something about the characteristics which enable us to 
distinguish economic goods from other goods. Under the present 
economic order, such a characteristic, and one very easy of appli- 
cation, is to be found in what we call exchange value or, still more 
exactly, price.^ The great majority of those goods which all recog- 
nize as economic enable their owner to command in exchange money 
or other economic goods; and, on the other hand, can be obtained 
by people who do not themselves produce those goods, only by giving 
in exchange money or other goods of the same general nature. 

^ This would not be true under a system of pure communism such as 
that which Russia apparently set out to establish in the fall of 1917. Un- 
der that system, there was to be no exchange, no selling and buying; yet 
there would surely be economic goods, since the people of Russia would 
continue, in the main, to feel the same wants, and so to need the same 
goods, as they had before the new system was introduced. 



2 PRINCIPLES OF ECONOMICS [I 

Since we are mainly concerned with the economics of the present 
order, it would perhaps be just as well at this stage of our study to 
leave the student to depend on this simplest test of what is and what 
is not an economic good. Experience, however, inclines me to think 
that considerable advantage would be gained if the student were 
to get at the very outset a deeper understanding of the real nature 
of economic goods. Before going on, therefore, we will attempt a 
little more thorough analysis of this matter. 

Economic Goods Conduct-Determining. — In trying to find a 
mark of economic goods which is more fundamental than mere 
exchange value or price, we first note a characteristic which, though 
possessed by many non-economic goods, after all shuts out a con- 
siderable number of them, and is at the same time of very great 
importance. That characteristic may be designated conduct-deter- 
mining or conduct-conditioned.^ That is, goods of this sort are 
goods which call on us for appropriate conduct : we need to act in a 
certain way to get these goods or to enjoy them. Thus, we can- 
not hope to possess the affection of our friends or the approval of 
our neighbors unless we conduct our lives in a suitable manner. 
The conduct-conditioned goods last named are, of course, not 
economic goods ; but the statement made in respect to them surely 
applies to goods of the latter kind also. Thus, we cannot hope 
to have clothing or food unless we expend effort and trouble produc- 
ing these things or producing other goods to exchange for them. 
Again, having obtained these goods, we could not hope long to enjoy 
them unless we were willing to take care of them, store them, guard 
them against thieves, protect them from fire, and so on. Economic 
goods, then, belong in the class of goods which are conduct-deter- 
mining or conduct-conditioned; and this is one of their most im- 
portant characteristics. 

Economic Goods Have Importance. — The last paragraph 
emphasized the point that the property of being conduct-determin- 



' These designations are not quite equivalent, but I shall take the liberty 
of using them interchangeably, choosing in each particular connection the 
one which seems most suitable. 



I] INTRODUCTORY 3 

ing, though not limited to economic goods, is one of the most im- 
portant characteristics of such goods. Another point needing com- 
ment is the precise reason why certain types of goods have this 
property of being conduct-determining. For, on this point, there is 
much erroneous opinion. The general answer to this question is 
to be found in the statement that goods of this kind have importance 
for us, our welfare depends on them, we have something at stake 
in them. But this, again, needs sharper definition. There is a kind 
of imporfe,nce which is not conduct-determining and therefore does 
not interest us, — is not a real, actual importance at all. The air we 
breathe has an importance of this kind. Importance it has, since 
without it we die. But, then, this importance is one which does not 
count; — from the practical standpoint it does not really exist, just 
because it does not call on us to regulate our conduct with respect 
to itself. Thus, we do not need to see that we are provided with 
air, do not need to worry about it, do not need to give it so much as a 
thought ; for it is supplied to us as a matter of course. 

Economic Goods Have Effective Importance. — This contrast 
between the kind of importance which does not make things conduct- 
determining, and the kind of importance which does, is sometimes 
expressed by saying that the former is merely potential importance, 
the latter actual importance. Again, that contrast is at times ex- 
pressed by saying that the former kind of importance is merely 
generic importance, while the latter is specific importance. The 
former phrase means that the goods in question have importance as 
a mere kind of goods; the latter means also that every unit of these 
goods which is at our disposal has importance. A phrase we shall 
often use instead of specific importance is effective importance. 

The point just made, we must emphasize still further even at 
the risk of being tiresome. For a failure to understand it is the cause 
of a very wide-spread and persistent economic error. From highly 
intelligent and often highly educated people, we are constantly 
hearing talk like this : "The valuations which society puts on things 
are incredibly absurd. Things which serve only for the satisfying 
of the most trifling of wants are esteemed more highly than things 
on which our very existence depends. We rate the services of a 



4 PRINCIPLES OF ECONOMICS [I 

professional singer, a Caruso, far above those of a coal miner or 
a farmer; we esteem diamonds infinitely more than bread; we pay 
teachers, who perform one of the most important of social functions, 
less than the poorest workman in an automobile factory." 

The answer to all this is that it confuses real, actual, effective 
importance with mere generic importance, and that it is usually ^ the 
business of society to concern itself, not with the generic importance 
of services or goods, but with their effective importance. To rate 
professional singers as such more highly than coal miners as such 
would of course be absurd ; and we may be quite sure that very few 
people could be found who really do so. If we had to give up all the 
singers or all the miners, we should without a second thought decide 
against the singers. But, under all ordinary conditions, no such 
alternative is presented to us. We are going to continue to have both 
Carusos and miners : we are simply called on to decide whether we 
need one more Caruso more or less than we need one more miner. 
From this standpoint, there is no room for any answer but the one 
people generally make : Important as miners are, when considered as 
a class, one miner more or less is very unimportant as compared 
with one Caruso more or less. The real effective importance of a 
Caruso is much greater than that of a miner. Society is not acting 
foolishly or thoughtlessly or wickedly in acting just as it does in 
evaluating the services of a Caruso far more highly than those of a 
miner. On the contrary, its evaluations at this point are just what 
they ought to be : they express the real comparative importances in- 
volved. 

Illustrative Problems 

I. The lumber of which a frame house is made has much more 
generic importance than the oxide of lead which enters into the paint 
which covers the house; yet a hundred pounds of lumber has much less 
effective importance than a hundred pounds of the oxide of lead. Ex- 
plain and defend both statements. 



'Circumstances arise under which society is in danger of losing some 
economic good altogether or, anyhow, seeing its stock seriously reduced, — for 
example, its forests. In such case, it must have regard to totals as well as 
units. 



I] INTRODUCTORY 5 

2. Rain and sunshine, though having vast generic importance, have 
no effective importance as the phrase is used in the text. Defend that 
statement. 

3. "Alone and lost in the desert, his last morsel of food and his last 
drop of water gone, he would cheerfully have given his gold, his yachts, 
his palaces, all his wealth, for the meager fare of the day laborer. At 
last the illusions which he shared with civilized society were fully 
dispelled. The unutterable folly of the comparative estimates which 
men commonly put on things became manifest. At last, on the verge of 
oblivion, he saw things in their true, their real, proportions." Criticize. 

Economic Goods Have Definitely Mensurable Importance. — 
The preceding paragraphs have narrowed down the field of eco- 
nomic study to those goods which possess effective importance 
and which, therefore, are conduct-determining. But we must carry 
further this process of delimitation. Not all goods which have 
effective importance can properly be designated economic goods, 
though this is one of the most essential characteristics of economic 
goods. Thus such goods as the affection of our friends and the 
respect of our neighbors are by universal consent excluded from this 
class. What, then, is the characteristic the absence of which shuts 
these out, — ^the presence of which makes a particular good truly 
economic ? This question is not an easy one to answer definitively ; 
and probably would be answered differently by authorities of equal 
standing. I am disposed to set up, as this final distinctive character- 
istic of economic goods, the possession by such goods of a special sort 
of effective importance, namely an effective importance which submits 
to more definite measurement than the importance of non-economic 
goods of this same general class. Stated still more specifically, under 
the present order, anyhow, strictly economic goods consist of those 
conduct-determining goods the importances of which can properly be 
measured and usually are measured in terms of money. 

Economic Value. — In the above discussion, I have purposely 
chosen to use the word importance in bringing out the distinctive 
features of conduct-determining goods, and, particularly, that class 
of such goods which we call economic. But, usually, we shall employ 



6 PRINCIPLES OF ECONOMICS [I 

for this purpose another term, namely, value. Exactly what signifi- 
cance ought to be attached to this term in economic discussions is not 
easily settled. In general, I am disposed to believe that the economist 
ought to have in the background of his mind the ordinary conception 
of value as significance to the well-being of man. Such a concept 
seems to me desirable as furnishing a link between the idea of im- 
portance and the idea of "conduct-determining." That is, because 
things have importance for us, they come to have value, and, because 
they have value, we regulate our conduct with reference to them. 
Perhaps the word "worth" helps to bring out this point. Conduct- 
determining goods are goods which are worth troubling about. In 
this broad sense of the word, value, all conduct-determining goods 
possess value. Wl^ien, in addition, the particular goods in question 
belong to that division of conduct-determining goods which we call 
economic, their value, like the importance from which that value is 
derived, is one which is capable of more definite measurement than 
is true of the other type, — is capable, that is, of pecuniary measure- 
ment. By economic value, then, we shall understand a worth or 
value thus capable of pecuniary measurement. Or, in short, economic 
value will be pecuniary value. 

Economic Goods Have Pecuniary Value. — It follows from 
what has just been said that, in defining economic goods, we may 
substitute for the phrase employed before, that is, importance capa- 
ble of pecuniary measurement, the simpler phrase, pecuniary value. 
In other words, economic goods consist of that large class of con- 
duct-determining goods which possess pecuniary value. But, now, in 
emphasizing as the final distinguishing characteristic of economic 
goods, pecuniary value, we must not forget that the word "value," 
as here used, means something deeper than exchange value, means 
worth or significance for man. This way of conceiving economic 
goods and value we shall frequently, though not always, have in 
mind when using these terms.* We should remember, however. 



* Let me say once for all that the term "value," as well as some others, 
will be used in a variety of senses. The policy, quite characteristic of 
logical minds, of trying to employ every term in just one sense, is almost 
always impracticable and productive of narrowness in one's thinking. The 



I] INTRODUCTORY 7 

that if our particular problem is to decide whether or not a given 
good should be accounted an economic good, under the present order 
the simplest test, and usually a perfectly adequate one, is the presence 
or absence of exchange value or price. 

Wealth. — Up to this point, in speaking of the goods v^^ith 
which the Economist is concerned, we have always referred to them 
as economic goods. I hardly need say that such goods are very 
commonly brought under the designation "wealth." This is a generic 
term applied to all goods which under the present order have ex- 
change value or price, and only to such. This practice makes it 
comparatively easy to decide whether or not a given object should 
be accounted wealth. It also helps us to work out for ourselves the 
other characteristics which goods that are accounted wealth must 
possess. For we need have no great difficulty discovering what 
characteristics must be present in goods for which people are going 
to be willing to give money. 

Illustrative Problems 

1. "In order to be an economic good — wealth — a thing must have 
utility, — must be capable of satisfying some want." Argue for the truth 
of this statement. 

2. Show that in order to be wealth a thing must be appropriable and 
transferable. 

3. Is the water flowing from a spring by the roadside wealth? 

4. Is an amiable disposition wealth? A hundred tons of gold known 
to be lying on the surface of the moon? A vein of coal existing, but 
not known to be existing, under a Michigan farm? 

5. It would cost a good deal of labor to cover the walls of the houses 
on Washtenaw Avenue with posters of a circus given two weeks ago. 
Would the result be wealth? What is the point to be made? 

6. "A thing may have value even though it is not useful: e. g., an old 
stone prized by a collector." Point out the error. 



real thing has many sides and there are not words enough to express every 
different aspect of it by a different term. 



8 PRINCIPLES OF ECONOMICS [I 

7. When we call a man wealthy we mean that he possesses a rela- 
tively large amount of this world's goods. Should we understand this to 
mean that the possessions of the poor man are not wealth ? 

Importance of Economic Study. — ^The preceding paragraphs 
have cleared up the concept of economic goods and their distinguish- 
ing mark, economic value. That these goods and the phenomena con- 
nected with them deserve serious study of some sort no one would 
doubt. If scientific curiosity did not suffice, the fact that these goods 
are conduct-determining, that we must act suitably or go without 
them, would surely settle the matter. Since we cannot have them 
unless we act in certain ways with reference to them, it surely 
behooves us to learn something about them and the conditions neces- 
sary to fulfil if we are to have them, in order that we may adjust 
our conduct accordingly, for, behind all correct, suitable action, there 
is surely an art, a body of rules which tell us the course which we 
need to pursue; and behind such an art there must be a body of 
scientific knowledge on which said rules are based. Economic 
conduct is no exception to this rule — men need a body of rules to 
guide their economic conduct; and that body of rules must rest on 
a body of scientific knowledge with respect to economic phenomena. 
We, therefore, have highly practical and powerful motives for 
developing and studying a science of economics. 

But just here is needed a word of caution. The scientific basis 
for any art, the body of knowledge lying behind any art, in most 
cases consists of materials derived from a number of different 
sciences. Thus, the art of making an automobile depends on the 
sciences of metallurgy, chemistry, physics, etc. To this rule, 
again, the art of economics furnishes no exception. This very making 
of an automobile just cited is in a sense a part of economic art, since 
an automobile is an economic good ; and, hence, the art of economics, 
in the broadest sense, builds on the sciences of metallurgy, chemistry, 
physics, etc. Similar statements would apply to many other 
economic activities. In fact, with respect to most parts of that side 
of economic art which has to do with the producing of economic 
goods, that art builds on non-economic sciences. Thus, manufac- 
turing in general builds on the sciences just mentioned in connection 



I] INTRODUCTORY 9 

with automobile production; farming builds on botany, zoology, 
chemistry, etc. ; mining, on geology, mineralogy, mechanical engineer- 
ing, etc. In other words, economics as a science does not claim to 
include the whole body of knowledge needed for the conduct of 
economic art. 

Scope of Economics. — But here, again, we must not go too 
far. It is true that the art of economics builds on many non-economic 
sciences. Nevertheless, when all these other sciences have made their 
contribution, there are kinds of knowledge not yet provided which 
are found to be needed, and supplying these gives rise to our special 
science, commonly called economics, or until quite recently, political 
economy. As to just what should be recognized as the proper 
boundaries of economic science, authorities are not yet agreed. Still, 
when it comes to determining the principal topics to be treated, there 
is no great difference of practice among the best writers. 

First, all agree in giving a very large amount of attention to the 
processes or principles under which value or price are determined,' 
some even going so far as to include no other topic save as it has a 
pretty close relation to the determination of prices. Another subject 
receiving much attention is distribution, the processes and system 
under which the sharing of the wealth and income of a community 
among its members is effected. In the present economic order, this 
is little more than a special division of the theory of price, for the 
reason that the determination of the incomes of the individuals is 
largely a matter of the prices received by individuals for the services 
they sell to other persons. As respects production, bringing into 
existence economic goods, a matter which, at first sight, might seem 
to be the most important thing in economic science, a large part of 
this, as already indicated, is relegated to other sciences, — ^the physical 
or technological side almost entirely so. Economics, however, keeps 
to itself certain of the most general aspects even of the technique 
of production, notably, the general conditions of productive efficiency. 
Further, most of the productive processes in which mental labor plays 
a large part, especially if these concern the exchange side of the 
business, are studied in sciences usually grouped under the head of 
economics. Conspicuous examples of this are business organization. 



lO 



PRINCIPLES OF ECONOMICS ' [I 



business management, marketing, and accounting. Again, certain 
lines of productive activity — certain businesses in their entirety— are 
reserved for economic science. Examples are banking and the dif- 
ferent kinds of commercial business, especially wholesale trade and 
foreign trade. Finally, the study of one public institution of the 
utmost importance in economic matters — money — is treated as being 
in a peculiarly important sense the task of economic science.^ 

Artificial Conditions. — In the above account of economic 
goods and economic phenomena, we have not hesitated to speak as 
if the case of economics and that of a science such as chemistry or 
physics were perfectly analogous. We ought now to remark on a 
difference of considerable importance between the phenomena with 
which we have to deal and the phenomena of the other sciences. The 
latter belong to a group of phenomena which are strictly natural, in 
the sense that they are not modified through conditions fixed by men. 
Economic phenomena, in contrast, belong to a group which are in 
'no small degree artificial : they are influenced by conditions of human 
origin. Of course all phenomena are natural in the broadest sense 
of the term. But, obviously, some are natural in a fuller and deeper 
sense than others. Now, many economic relations are among the 
most truly natural and inevitable that can be formed ; many economic 
phenomena would be just like those we are familiar with in the same 
connections, even if we lived like Crusoes or, at the opposite extreme, 
like a communistic society. But, in contrast with these, not a few 
economic phenomena would be very different from what they are 
now, provided the conditions fixed by men were altered. For ex- 
ample, if legal changes were introduced giving the state ownership 
of all the land, the amount of wealth enjoyed by many persons would 
be quite different ; if all undertaking of production were legally left 
to the state, more or less conspicuous changes in price would probably 
take place ; and, again, if the laws permitted us to own laborers like 
beasts of burden, this circumstance would surely modify many 
economic phenomena. It is plain also that such conditions may be 
brought about not only by formal legislation but by custom, conven- 



* This does not apply to the techniqae of its manufacture. 



I] INTRODUCTORY II 

tion, or formal agreements. Thus, a general boycott of manufac- 
turers who employed non-union laborers would be an artificial con- 
dition of sufficient significance to influence wages and employment 
quite seriously. 

An Economic Order. — The point just made, that artificial 
conditions play a considerable part in determining economic phe- 
nomena, naturally brings us to a concept which has already appeared 
in this text under the phrase "economic order." By this I mean 
the totality of artificial conditions, whether originating in law or 
custom, under which economic phenomena manifest themselves. 
Such a concept is necessary to the study of economic science because 
the potency of artificial conditions to influence economic affairs 
makes possible the existence of general situations in economic mat- 
ters which differ so essentially that a body of scientific principles 
applicable to one of these would be quite inadequate for another. 
Many such economic orders are possible; but only three, or some 
combination of these, receive serious consideration. These three are 
the present order, socialism, and communism. Quite naturally, our 
study is largely limited to the present order. Not infrequently, how- 
ever, that study is illuminated by imagining how things would work 
under a communistic or socialistic order. 

Unity of Economic Science. — The emphasis just laid on the 
possible variations in economic principles growing out of artificial 
differences — differences in the particular economic order prevailing 
— must not be taken too seriously. A very large part of the science 
of economics, a much larger part than is commonly supposed, would 
be the same under any economic order. This applies not only to such 
technical matters as the most efficient methods of production, a thing 
which, of course, cannot be changed by legislation or custom, but 
also to the most distinctively economic of all the problems of our 
subject, the theory of value in its deeper aspects. By this I mean 
the problem, what are the true importances or values of goods in- 
herent in a given situation, values which a wise socialistic government 
would try to make their guide in the conduct of economic affairs, 
and which the defenders of the present order claim are in a fairly 



12 PRINCIPLES OF ECONOMICS [I 

high degree represented in the system of prices automatically worked 
out under that order ? The mature student of economic science and 
economic practice will, I think, be impressed by the essential oneness 
of fundamental economic phenomena under all systems and in all 
times and places, much more than by their differences. 

Economics a True Science. — Up to this point, it has been 
assumed as a matter of course that economic phenomena will repay 
serious study, that such study will yield a body of knowledge which 
may properly be designated a science. This, perhaps, seems too 
optimistic, in view of the fact that we often hear people declare very 
positively that there is no economic science, that there are no economic 
principles, that in economic matters we could not make the smallest 
prediction with any hope of its being fulfilled. Such statements, 
however, are not to be taken seriously. Any person can, on the 
spur of the moment, make many predictions in economic matters, 
and look forward to their fulfilment with perfect assurance. 

For example, if there should be a great falling off in wheat pro- 
duction next year, the price would certainly rise. If, by the intro- 
duction of new methods, the cost of producing almost any manu- 
factured article were to fall fifty per cent, — monopoly being shut 
out — the price of such article would also fall. If the price of 
aluminum should decline fifty per cent there would doubtless take 
place a great extension of its use in the arts. If the government 
should begin to coin freely both gold and silver, putting only sixteen 
times as much silver into that kind of coin as it did of gold into 
that kind, when on the open market an ounce of gold was worth, say, 
forty ounces of silver, the silver would surely get the place of 
standard money while gold would go to a premium and rapidly dis- 
appear from circulation. And so one might go on. In short, 
economic phenomena, like any other phenomena, are governed by 
natural laws. If the group of phenomena in question are of such a 
kind that several almost equal forces are interacting, it may be im- 
possible to anticipate the result, just as in complicated natural or 
physical sciences like physiology or meteorology. But in other cases, 
when only one or two of the forces in operation are of much signifi- 
cance, it will be comparatively easy to ascertain the probable outcome. 



I] INTRODUCTORY 1 3 

Economics Abstract and Hypothetical. — As respects its gen- 
eral method of procedure, economics does not differ essentially from 
other sciences. Like all thinking, studying, knowing, it has to be 
abstract; that is, it has to withdraw its attention from many of the 
causes and conditions affecting the phenomena studied, and confine 
that attention to a few of these. Further, economics is hypo- 
thetical as well as abstract. By this I mean that economics assumes 
a uniformity in the few causes and conditions which it elects to study, 
that in reality does not exist. Thus it not only confines its atten- 
tion largely to the working of intelligent selfishness in economic 
affairs, ignoring the influence of religion, ethics, sympathy, and so 
on, but it also thinks of that intelligent selfishness as having a quite 
unreal uniformity in respect to both the stimuli to which it responds 
and the energy which it displays in making this response. 

Economic Abstraction Sound. — Because of the characteristics 
jiust brought out, there is always danger that the results obtained from 
our study will have but little application to actual affairs. Such 
danger is present in all science, just because science is necessarily 
abstract. But the student of every subject, in making his abstrac- 
tions, endeavors, of course, to choose for study those causes and condi- 
tions which are most fundamental and most powerful among those 
bearing on the case. In so far as he succeeds in this endeavor, the 
results which he obtains disclose the fundamental and principal rela- 
tions among the phenomena involved. Like the teacher of anatomy, 
the teacher of economics begins by trying to supply the student 
with the main framework of his subject, a framework which is not 
easily seen because of the wealth of material which covers it within 
and without. Doubtless, in spite of all his care, the teacher of 
any subject may err in the picture which he gets and which he 
gives to others. In abstracting particular phases of his subject for 
study, he may choose trifling things instead of important ones and 
receive and impart a totally erroneous impression. But, surely, the 
chances are against that result. Certainly, in the case of the econo- 
mist, there is a strong presumption that he has succeeded fairly well in 
avoiding such dangers, since, in spite of much seemingly violent 
controversy, there is very substantial agreement among leading 



14 PRINCIPLES OF ECONOMICS [I 

economic writers in respect to all of the most fundamental and most 
important doctrines. Textbooks prepared for the general course in 
economics, by adherents of different so-called schools of economic 
thought, show a very high degree of similarity. 

Apply Principles with Caution. — We have just defended the 
actual abstractions made use of by economic science as being sub- 
stantially sound, not confining attention to trifles and ignoring the 
more important causes and conditions at work. We must not, how- 
ever, permit ourselves to forget that, after all, economic science is 
abstract. It does not attempt to cover the non-economic forces at 
work in any given case, nor even all the economic forces. Accord- 
ingly, it is of great moment that we should remember that we are not 
justified in making a direct and immediate application of the knowl- 
edge derived from a course like this to the settlement of practical 
problems, such as a protective tariff, governmental control of rail- 
roads, labor legislation, etc. Such procedure is not justified in any 
science ; since, whatever the science one is studying, some time must 
be spent mastering those most general principles the actual working 
of which, though fundamental, is, after all, much modified by the 
operation of more superficial forces. In the case of economic phe- 
nomena, the too hasty application of fundamental principles to specific 
problems is even less justified than elsewhere, because of the great 
number of economic and non-economic forces, which are simulta- 
neously acting at any given moment and which make the accurate dis- 
entangling of causes almost impossible. It is, therefore, quite im- 
portant that the student should exercise much self-control at this 
point. In particular, he is urged to suspend final judgment on almost 
all great practical problems, such as free trade, socialism, trades 
unionism, etc., till he takes courses subsequent to Course i. 

In making use of the present text the advice just given is 
especially needed because, in the process of trying to secure a 
thorough comprehension of principles, it seems necessary to make 
many applications of those principles to actual problems. If, how- 
ever, the student will remember that in these applications we are 
concerned only with the economic phase of the problem, while in 
actual life the problem has many other phases, he will realize that 



1] INTRODUCTORY 1 5 

at present he should attempt to reach a final opinion, not on the whole 
matter, but only on its economic phase. 

As already implied in the foregoing, the course upon which we 
are just now entering is primarily intended as a foundation for later 
study. It is, therefore, devoted to a severe discipline upon funda- 
mental principles and their applications. In general, our method of 
procedure is to introduce the concrete phenomena needing explana- 
tion ; then to set forth in formal fashion the principle which embodies 
the explanation; to follow this with adequate illustration and argu- 
ment ; then to finish with illustrative problems the solving of which 
will insure that the student really masters the principle involved. 
We advise that, in preparing the lesson, the student begin by reading 
the text carefully, though not attempting to master it; that he then 
undertake to solve the illustrative problems, recurring to the state- 
ment and discussion of principles as he feels the need therefor ; and 
that, finally, he go over the entire discussion once more in order the 
better to comprehend it as a whole. From the problems he can obtain 
the best results by writing out the solution. In doing this, he should 
not rest satisfied with categorical answers even when these seem suf- 
ficient, but rather take pains to explain — ^give reasons for — ^the con- 
clusion reached. It is essential above all that he should cultivate 
clearness and precision of statement and, where argument is needed, 
should be careful to include every link of the chain and to put each 
in its proper place. 



CHAPTER II 

GENERAL SURVEY OF THE EXISTING ECONOMIC 

ORDER 

In the introduction we developed, among other things, the notion 
of an economic order — a totahty of conditions under which economic 
phenomena take place; and we explained that our study is mainly 
concerned with the particular economic order now existing, — the 
phenomena displayed under it and the natural laws governing those 
phenomena. Our first task, before undertaking a detailed study of 
the economic order, is to get a general view of it and familiarize our- 
selves with its most conspicuous features. To this task we shall 
devote ourselves in the present chapter and the next. 



The Present Order One of Individual Exchange-Cooperation 

The general situation in which men find themselves is this : First, 
they exist, and by the fact of their existence they have wants which 
imperatively demand satisfaction. Secondly, the satisfying of these 
wants depends on the possession of certain economic goods. Finally, 
the getting of the goods depends on some acts, efforts, of man him- 
self. Speaking broadly, man must make his own living. He must 
perform some part, large or small, in the process by which he becomes 
possessed of the necessary goods. Now, as making possible the ac- 
complishment of this task, he finds at his disposal two sets of condi- 
tions, or instrumentalities : ( i ) his own outfit of capacities, mental 
and physical, and (2) an outside world of material objects and con- 
ditions which in one way or another can be drawn upon and utilized. 
Starting with this general situation, there are several possible ways in 
which his task of making a living might be accomplished, 

16 



II] GENERAL SURVEY 17 

Different Possible Economic Orders. — First, an economic 
order can at least be conceived in which the goods needed by the 
individual are made available by his own efforts, unaided by his 
fellow men. Crusoe is represented as contriving to satisfy his wants, 
m so far as they were satisfied at all, almost wholly by the labor of 
his own hands; and it is probable that many hunters and explorers 
for a time approximate his condition. A pioneer or isolated settler 
also to a great extent produces the very things which he consumes 
and consumes nothing but what he himself produces — ^bakes his own 
bread and eats it, grinds his own flour and bakes it into bread, raises 
his own wheat and grinds it into flour. Such an order, where each 
man provides directly and entirely for the satisfaction of his own 
wants, may be called an autonomous economic order. 

At the opposite pole, we have an economic order in which all 
the people of a community cooperate in a completely organised way 
in the getting of economic goods. The community owns all the re- 
sources, undertakes all production, and sees that each person gets 
what he needs or, anyhow, what the community can afford to let him 
have. Such an economic order is commonly designated Communism. 

A somewhat less completely organized system of cooperation 
would leave to individuals greater freedom of action, in that, while 
the community owned all goods used in production and undertook 
all production, the individual would be hired by the community and 
paid wages, and would be permitted to buy and own such consump- 
tion goods as he chose, instead of being taken care of like the mem- 
bers of a family. A system of this general character is usually 
called by economists Socialism or Collectivism. 

The two possible economic systems last described are both co- 
operative, as must be all but the one first described — ^the autonomous 
one. But neither of these, as the student is doubtless aware, is any- 
where fully established, though experiments in this direction are 
being made on a gigantic scale in various countries. In contrast, the 
actual system of most civilized countries is one in which the co- 
operation involved, instead of being organized, conscious, is rather 
spontaneous, automatic — effected and regulated through free ex- 
change between individuals or non-political groups. This system we 
shall call one of Individual Exchange-Cooperation. 



l8 PRINCIPLES OF ECONOMICS [II 

The Present Order Cooperative. — Bui we need to make some 
more specific comments on this order. First, we must emphasize the 
general point that the system is cooperative. This is necessary for 
the reason that not a few people are accustomed to think of this order 
as emphatically not cooperative. In fact they very often urge the 
adoption in its place of some system which is cooperative. Now, of 
course, it is perfectly legitimate to understand cooperation in senses 
which would not be suitable in describing the present order. For 
example, there is a special system of acting together among the con- 
sumers of certain types of commodities whereby they themselves 
undertake the business through which these commodities are obtained. 
Thus we sometimes have cooperative bookstores in college towns. 
In England there are many cooperative shops for groceries, meat, 
and other household supplies. Again, we have a few cases of 
producers' cooperation, wherein the laborers in a business under- 
take to run that business. Other uses of the term could doubtless be 
found.^ So, of course, the communism or socialism described above 
would be cooperative in a sense that the present order is not. Never- 
theless, it is unquestionably true and of the greatest importance that 
the present order is cooperative. For it contains the essential 
feature of cooperation. The members of society act together in 
supplying their wants. Each person produces almost entirely for 
other people's consumption; each person consumes almost entirely 
what other people have produced. 

Spontaneous Exchange-Cooperation. — We have seen that the 
present economic order is essentially cooperative. A second special 
characteristic of that order is found in the peculiar way in which our 
cooperation is brought about. Ordinarily, in speaking of coopera- 
tion, we think of it as being conscious, organised cooperation, brought 
about either by agreement or authority. Thus, people cooperate in 
getting up a church supper or picnic, through agreement. On the 



* It perhaps ought to be added that people every now and then use 
the word cooperation for a species of acting together, which most economists 
condemn, that is, the acting together of persons engaged in the same 
business. "We are hurting ourselves by this heartless competition," say the 
grocers; "let us cooperate, — treat each other as brothers, — live and let 
live." Very nice for the grocers, but hard on the rest of us. 



II] GENERAL SURVEY ig 

other hand, in the family we have cooperation brought about by the 
authority of one or both the parents, and in communistic societies — 
Shakers, Oneida, Amana, — many of which have existed in the United 
States, we have cooperation effected by the authority of the com- 
munity. In contrast with such conscious, organized forms, the co- 
operation of the present order results from the spontaneous action of 
individuals in producing goods wanted by other persons, and ex- 
changing those goods for goods which the others have produced. 
That is, the element which effects our cooperation under the present 
order is Exchange. This second feature of the order is brought out 
by denominating that order one of Exchange-Cooperation. 

Cooperation Regulated through Exchange. — A third charac- 
teristic of the present order, and one which furnishes an additional 
reason for denominating it an order of Exchange-Cooperation, is 
found in the way our cooperation is regulated. It is pretty clear 
that, if we have any cooperation at all, there must be some way of 
regulating that cooperation. We need more of some things than of 
others. We need certain things so much that it will pay us to have 
them even at the cost of going without some other things altogether. 
Unless there is some guiding, directing machinery, we shall be wasting 
our resources producing the wrong things or the right things in the 
wrong proportions. Now, in some kinds of cooperation this regulat- 
ing is done, or would be done, by authority. This is the case within 
the family. How much time the farmer's boy shall put in weeding 
the garden, how much splitting wood, and how much picking up 
stones, the farmer determines by authority; and such a system 
prevails in the main in the communistic societies to which reference 
has already been made. But, throughout most of the present order, 
our cooperation is regulated by the same machinery of exchange 
which effects that cooperation, and in the same spontaneous way. 
If too little of anything is produced, price rises or the market ex- 
pands, profits increase, and so producers of their own motion increase 
output ; if, on the other hand, too much of anything is produced, price 
falls or the market contracts, profits diminish, and so producers of 
their own motion diminish output. Again, if the output of some 
commodity during a particular year is exceptionally small, so that 



20 PRINCIPLES OF ECONOMICS [II 

consumption all along the line needs to be curtailed, this is usually 
accomplished, not by the interposition of the public authorities, but 
by an automatic rising of price which induces almost every one to 
cut down consumption of his own motion. So, in these and various 
other ways, exchange regulates our cooperation. 

Individual Initiative. — We have seen that the present 
economic order is one wherein men cooperate and wherein their co- 
operation is effected and regulated through exchange. The fourth 
and last dominant feature of the order is individual initiative. It is 
quite possible to conceive a system of cooperation which, in part at 
least, is effected and regulated through exchange, but in which 
initiative is left to society as a whole, government. Thus, under 
socialism as it is commonly advocated, the state would be the sole 
farmer, miner, manufacturer, or merchant, — the state alone would 
undertake to produce things, putting. all individuals into the position 
of employees. But it would still enter into exchange relations with 
these individuals, buying their services in the open market and selling 
them its products. Further, it very probably would depend on freely 
determined prices to guide or regulate production in the same way 
that they do at present. But while such a system would, like the 
present, be a system of exchange cooperation, it would differ radically 
in leaving all initiative to the state; whereas, in the present order, 
initiative is mostly, though not entirely, the business of the individual, 
— persons who have the means and think they see a chance to obtain 
profits set about producing wheat or iron or chairs or what not. 
Accordingly, to give something like a complete characterization of 
the present order in its most general features, we have to say that 
it is a system of Individual Exchange-Cooperation. 

One point in the foregoing description should perhaps receive 
special emphasis before we pass on. Our affirmation that the existing 
order is regulated through exchange may awaken surprise or doubt 
in some who were unaware that the order is regulated at all. Many 
people have never recognized in exchange the possibilities of a 
regulating factor ; they have assumed that the only such factor that 
could exist is some kind of conscious interference ; and, knowing 



II] GENERAL SURVEY 21 

that there is little such interference in our order, they pass to the 
natural conclusion that our order is almost, if not entirely, unregu- 
lated. Indeed, there is nothing more common, even among educated 
people, than the notion that, save for a slight authoritative inter- 
ference here and there, the present order is quite without regulation, 
and therefore exists in a state of chaos or anarchy, governed only 
by chance. Now, this is surely quite contrary to the facts. Economic 
actions are regulated actions. They are organized and correlated so 
as to accomplish uniform and regular results. The fact that the 
regulation is spontaneous, and hence to some extent concealed, does 
not make it any the less real. It would be impossible, or at any 
rate inexpedient, to attempt in this place a fuller description of 
the process by which the regulating actually takes place. But the 
more specific and detailed argument for it will be supplied as our 
knowledge of the economic order expands in the progress of this 
course. 

In saying that the economic order is regulated, we do not intend 
of course to intimate that it is regulated in a manner altogether just 
and expedient. The time has not come to go into this topic at all 
fully ; but even at this stage so much should be made clear. No one 
claims that the present system works perfectly, that there are no 
evils which society ought to try to eliminate. There surely are not 
a few places where spontaneous regulation fails to attain good re- 
sults, and it surely is possible that at these points some other form 
of regulation would do better. But even so, we must still insist that 
the present order is not chaotic, that it is a regulated and a ration- 
ally regulated order, though one in which the process of regulation 
is automatic. 

Illustrative Problems 

1. Give some examples of autonomous production from everyday 
experience. 

2. "Robinson Crusoe, on his far-away island, had neither trade nor 
commerce. Except for the supplies that he recovered from the wreck 
of the ship, he obtained his food from the plants that he cultivated and 
from the wild animals that he killed. His clothing was made from the 
skins of goats ; his table and his chairs were the work of his own hands. 



22 PRINCIPLES OF ECONOMICS [II 

Even his shelter was constructed of the stone and wood that he found 
on the island. If he had more of one product than he needed he could 
not exchange it for other necessary articles. If provisions, utensils, 
clothing, tools, or metals were lacking, he could not buy them. He was 
by turns hunter, fisher, tanner, farmer, miller, baker, blacksmith, and 
carpenter." 

The above is the opening paragraph of a book on Commercial 
Geography. It seems intended to suggest the significance and importance 
of commerce by setting forth the disadvantages of isolation such as 
Crusoe's. What was the real nature of the drawback in his situation 
which it brings out? 

3. "In the main, industry is organized in a spontaneous way. Men 
choose such occupations as they like, and when there are too many of 
them in one group and too few in another, the automatic working of 
economic forces moves them from the former to the latter." Explain 
and illustrate the last clause of that sentence. 

4. "The great advantage of foreign trade is in furnishing a market 
for our surplus products which would otherwise go to waste." This 
surely is only a minor advantage of foreign trade. Why? Give some- 
thing better. 

5. If the potato crop of a communistic society which had no com- 
merce with other communities were to fall off one-half, how would they 
regulate the consumption of potatoes for the following year? How is it 
done under the present order? 

6. "It will never pay us to import anything which we ourselves can 
produce." Show that this proposition is erroneous. 

7. "If the results which follow from allowing prices to be determined 
under the free working of economic forces do not satisfy us, we should 
try to improve those results by the adoption of subsequent measures, — 
we should if possible avoid all direct interference with the free determi- 
nation of prices. 

Defend that statement. 

8. Suppose that a wave of sentiment in favor of higher wages for 
workmen in one particular industry, say railway transportation, passes 
over the country, and as a result these wages are actually pushed much 
above what they would tend to be under the natural working of things. 
Argue that such a policy would be inexpedient. 



II] GENERAL SURVEY 23 

II 
Forms and Forces of Individual Exchange Cooperation 

Specialization. — To a very limiled extent, our cooperation in 
the present order is homogeneous ; we combine to do something which 
requires that all shall act in the same general way, as when a number 
of men carry a steel rail. But, generally speaking, our cooperation 
is heterogeneous. Each person does a different thing from the rest, 
though the actions of all may be combined and ordered to a common 
end. But this differentiating the tasks involved in the cooperative 
process and assigning them to different persons is not something 
merely occasional or extemporized. The particular task undertaken 
by each is habitually undertaken by him; he regularly performs this 
task and no other. Now, such a practice is known as division of 
labor or specialization. And this specialization, as one of the most 
important features of our cooperation, should be examined somewhat 
more specifically. 

One form of specialization is that wherein each producer is en- 
tirely responsible for a complete product. Thus the farmer plants 
his potatoes, hoes them while they are growing, and finally digs and 
sorts them into bags, ready for the consumption of his several neigh- 
bors; while one of those neighbors, the carpenter, might draw the 
plans for a house, procure the lumber therefor, and finish the structure 
complete, ready for the farmer's occupancy. 

But, as every one knows, specialization commonly goes much 
further than this. Practically no one in a highly organized society 
carries from beginning to end the processes necessary to the produc- 
tion of a finished consumption good. The work of the baker in 
producing bread is preceded by that of the miller in producing flour 
and that of the miller in turn by the work of the farmer in producing 
wheat. So likewise the work of the shoemaker is preceded by that 
of the tanner, and the work of the tanner by that of the stock-raiser. 
Each commodity, in short, comes to its ultimate consumer as a result 
of efforts spent upon it by a long series of different producers. In 
addition, the various members in the original series make use of 
the products and services of producers in various other series. Thus 



24 PRINCIPLES OF ECONOMICS [II 

the cattle-raiser avails himself of the wagons, harness and wire 
fences produced by certain manufacturers. The tanner, again, uses 
coal, bark, and cloth, and the shoemaker uses thread, bristles, needles, 
and machinery, each of which has been brought to perfection by as 
many and various independent series of producers. 

Internal Specialization. — But in an economic society so highly 
developed as ours, cooperation and specialization go still further than 
we have yet indicated. In the case last mentioned we were thinking 
of industrial units which, though devoted each to producing only a 
single element in the ultimate product, were yet undivided units. 
It was the stock farm as a whole which we conceived of as raising 
cattle and the tannery as a whole which we conceived of as preparing 
hides for leather. But in reality each such industrial unit is divided : 
there is specialization within it. In the tannery which as a whole 
produces leather, some men attend to the scraping of hides, some to 
the curing of the hides in the various baths, some to staining, some 
to finishing, some to keeping books, some to writing letters. 

Specialization in All Factors. — A point with respect to spe- 
cialization which is much too important to be neglected may naturally 
be presented in this connection. Specialization is not limited, as 
may seem to have been implied in the preceding discussion, to human 
beings. For human beings necessarily use lands, machinery, and tools 
in their work ; and these assisting factors become specialised just as 
do the men themselves. Each tool and machine is more and more 
confined to the performance of one small job; one portion of land is 
devoted to celery, another to onions, another to citrous fruits, and 
so on. 

Functional Specialization. — But we have not yet brought out 
the full extent of specialization under the present order. The spe- 
cialization thus far considered grows more especially out of the 
differences in the physical or technical operations to be performed 
in getting a product ready for consumption. But there is an even 
deeper kind of specialization. In speaking of it we shall be antic- 
ipating somewhat the contents of a later chapter, but the broad facts 



II] GENERAL SURVEY 25 

can after all be very easily understood. We already had occasion in 
the last paragraph to mention the fact that when a man engages 
in productive operations he does not work alone, but brings to the 
aid of his labor various factors outside himself, land and materials, 
tools, machinery, etc. Now, with the development of industrial 
society under a system of exchange cooperation, it has come about 
that the labor for productive operations is furnished by one person 
or class of persons, the land by another, much of the capital invested 
in tools, machinery, etc., by another, and the initiative in, or responsi- 
bility for, production by still a fourth. The people furnishing these 
different necessary factors may therefore be said to specialize. Here, 
manifestly, we have a deeper sort of specialization than anything yet 
considered. For lack of a better term I will designate it functional 
specialisation. 

To summarize this discussion : the present economic system pre- 
sents itself to us as one wherein we have a vast complex of different 
industries — mining, stock-raising, farming, manufacturing, transport- 
ing, etc. — each concerned in the production of some commodity at 
one or another stage of completion ; that, within each of these indus- 
tries, different functional groups of productive agents are cooperat- 
ing, and that, finally, this vast industrial complex is brought to- 
gether, is held together, and is regulated through exchange — buying 
and selling. The existing system is thus seen to be one of extraor- 
dinary complexity, very confusing to the general public and not a 
little so to the trained thinker. It is often difficult to isolate the pre- 
cise function performed by a given business, and people who form 
hasty conclusions are apt to deny the existence of such a function, to 
affirm that the business in question plays no legitimate part, so that 
those who pursue it are mere parasites upon society. We shall do 
well, however, to assume at the outset that every occupation not 
catering to human vice plays a real and legitimate role in the total 
conduct of economic affairs, is doing some one of the numberless 
things necessary to be done if the wants of mankind are to be satis- 
fied in the fullest possible measure.' 

Competition. — We have remarked on some important phases 
of the specialization which forms so vital an element in the present 



2.6 PRINCIPLES OF ECONOMICS [II 

economic order. We must now comment on another very important 
element in this order, an element which is often thought of as the 
most characteristic feature of the system. That element is 
Competition. 

Dangers Incident to Cooperation. — To begin with, let us re- 
mind ourselves once more that the present economic order is a co- 
operative one. Most of the goods we produce are destined to satisfy 
the wants of other people ; and most of the goods destined for the 
gratification of our wants are produced by other people. But, now, 
very little reflection is needed to convince any person that, when 
people cooperate, whether in an economic order like the present one 
or in an order like communism or socialism, there will always be a 
temptation assailing each one to give to the joint output as little as 
possible and to take from that joint output as much as possible. Just 
because I am producing things for people other than myself, I might 
easily be tempted to put poor materials into my product, to avoid 
working very hard or very carefully on that material, to try to get 
from my customers prices for my product higher than their real 
value, and so on. In fact, as we all know, this is in some measure 
true of the present system as it really works. 

Methods of Meeting Those Dangers. — But it is hardly neces- 
sary to say that society has always recognized this danger and the 
need for some plan or device for meeting it. In a society where volun- 
tary communism has been maintained, the influence of a sense of 
religious duty has usually been depended upon, though without great 
success, to accomplish the result. Under socialism and state com- 
munism, public authority would probably be used to meet this need, 
as would seem to be the case in Russia at the present time. But, 
under an order of free private initiative, such as ours, the force 
commonly depended upon is jree competition, — ^that is, the un- 
hindered effort of each producer to get or keep patronage which 
might go to rivals. 

Presumptive Efficiency of Competition. — The a priori grounds 
on which we might expect free competition to guard us pretty well 



II] GENERAL SURVEY 2/ 

against the dangers incident to all economic cooperation are easily set 
forth. If, as a producer, I had no need to think of anyone but my 
customers, the temptation to gain at their expense which has been 
noted might generally prove too strong. But there are other people 
whom I have to consider, namely, my rivals, other persons producing 
in the same line as myself. The fear that such persons will get my 
customers to buy from them instead of from me, says to me in very 
emphatic tones : Do nothing to the disadvantage of your customers ; 
don't put in poor materials or work ; don't take advantage of their ig- 
norance ; don't try to deceive them ; and so on. Put positively, that 
fear of rivals says : Do everything possible to the advantage of cus- 
tomers ; be eager to anticipate their wants ; put in better and better 
materials; improve the quality of your work; show yourself really 
interested in doing the best you can by them ; and so on. Manifestly, 
we have here a force which tends strongly to offset the dangerous 
tendencies naturally present in all cooperation. 

Enforced Freedom of Competition. — That free competition 
must be recognized as a vital, fundamental necessity of the present 
order is surely evident from the considerations set forth in the last 
two paragraphs. Conceivably it might be better to do away with our 
present system altogether, to substitute therefor a system of organised 
cooperation like socialism, in which case we should have to depend 
largely on some other method of avoiding the dangers which grow 
out of cooperation. But, so long as we attempt to maintain the present 
system of spontaneous cooperation, we should in every way strive to 
maintain freedom of competition. And, in fact, this is the almost 
universal policy of governments at the present time. The only ex- 
ceptions are those cases where experience has shown that free compe- 
tition cannot be maintained or its maintenance will on the whole 
work more evil than good. With these, government control or gov- 
ernment regulation is substituted for freedom of competition. But 
these cases are decidedly the exception. The general rule is enforced 
freedom of competition. Even when governments undertake direct 
control or regulation, they usually set up as the ideal of their regula- 
tion the results which it is conceived would follow were competition 
perfectly free. 



28 PRINCIPLES OF ECONOMICS [II 

Competition Versus Cooperation of Like Units. — The im- 
portance of free competition in the present system makes it almost 
necessary to comment on a certain matter-of-course condemnation of 
such competition which has very wide vogue. Certain types of men 
talk and write with much eloquence about the wicked and unchristian 
character of competition, and roundly affirm that cooperation would be 
so much better, so much more human and christian, meaning by co- 
operation this time, cooperation among like units, like producers. If 
such cooperation is being carried out by very wealthy men in great 
corporations like the Standard Oil Company, the enthusiasts for 
cooperation talk in a different vein. In fact, they are quite likely to 
indulge in disagreeable epithets such as "grinding monopoly," "the 
robber barons of our day," and so on. But cooperation which is 
limited to their own particular group and so is likely to serve their 
selfish ends, or cooperation which applies to some class with which 
they have special sympathy, they defend in warmest language. 
Whether there is any possible justification of such an attitude, I will 
not here attempt to say. One thing, however, is certain. Any notion 
that free competition is per se wrong, that cooperation, in the sense 
here considered, is inherently the only righteous policy, — any such 
notion is thoroughly unsound. In fact, the truth is precisely contrary. 
Only free competition is right; cooperation is, prima facie, wicked. 
Cooperation, in the sense indicated, is only a pleasant name for com- 
bining to take advantage of your customers, or the dealers of whom 
you are customers. 

Competition as a Regulative Instrumentality. — We have seen 
the importance of free competition as the instrumentality depended 
upon to hinder the selfishness of the individual from interfering 
seriously with the working of the present order in respect to fairness 
and efficiency. Attention ought also to be called to the part played by 
competition as a regulative instrumentality. Every person who en- 
gages in production hopes, of course, to dispose of his own goods and 
obtain other goods in spite of the presence of his competitors. But, 
in order to exchange at all, one must accept as low prices and pay as 
high prices as his competitors. Now for the individual this necessity 
may prove to be extremely trying. It often costs one man more to 



II] GENERAL SURVEY 



29 



turn out his products than it costs his competitors, and so if he sells 
as low as they, he may get out of the exchanging process less than he 
puts into it. And if he continues long doing business on any such 
principle, he will of course come to ruin. 

Now the real difficulty with any individual in this situation is 
that he has not been able to produce the particular commodity which 
he brings to exchange as efficiently or as cheaply as his competitors. 
To save himself, therefore, he will be forced to quit that field of 
production and go out seeking among other fields for one in which 
the advantage does not lie so much with his competitors. Only those 
with independent incomes can choose and indefinitely persist in an 
occupation which does not produce something they can sell to ad- 
vantage. In other words, the result of competition, of competitive 
exchange, is to force each person into that field of productive employ- 
ment for which he is best fitted. Specialization, as already pointed 
out, is an essential feature of our cooperative order. Hence, competi- 
tion, which guides our specialization, which leads us inevitably to 
specialize in the employment where we can produce most efficiently, 
which makes our specialization more perfect — is also cooperative. 
Its final result is the more effective satisfying of human wants as a 
whole. 

The most essential points presented in this chapter regarding the 
existing economic order, may now be summarized as follows : Indi- 
viduals produce separately, and on their own initiative, specializing 
in the production of certain economic goods. These goods they then 
proceed to exchange for goods produced by others. And the ex- 
changing process, being carried on competitively, results in the fixing 
of those prices which regulate the economic order, and which make 
it an order truly cooperative. 

Illustrative Problems 

1. Is it consistent with the general character of the present economic 
order that all the orange growers of the country should combine for 
the marketing of that product? That all grain raisers should combine 
in the purchase of binding twine? 

2. Is it consistent with the general character of the present order 
that all the locomotive engineers of the country should combine in selling 



30 



PRINCIPLES OF ECONOMICS [II 



the services of some of their number to the Michigan Central Railway? 
Would it be any more consistent with the present system if this com- 
bination sold the services of all their number to all the railroads acting 
as a unit ? Would the second plai^ seem to you any fairer ? 

3. Two ladies discussing the high level of prices in the winter of 
1920 agree in holding this doctrine: "During the last few years pro- 
ducers have learned that they can make more money by keeping down 
the output and so raising prices. Hence we can be quite sure that in the 
future they will pursue this policy : from now on we shall commonly have 
a shortage of wheat and fruit and other farm products." Criticize that 
conclusion. 

4. We hear a great deal of complaint in these days to the effect that 
dealers, middlemen, are getting outrageous profits. Doubtless there is 
always a possibility that the unexpected will happen; but, provided 
competition is kept free, the presumption is always against the truth of 
such an accusation as the above. Defend the last statement. 



Ill 

Some Economic Principles Deducible from the General Nature 
of the Present Order 

Prevalence of Economic Fallacies.— A notable fact in this age 
of general education and enlightenment is the continued acceptance 
by a great majority of persons of quite erroneous notions with respect 
to several familiar and not very difficult economic questions. One can 
hardly run through a current newspaper or popular magazine without 
coming upon fallacies which, as the economist looks at it, were fully 
disposed of by Adam Smith almost a century and a half ago. This 
prevalence of unsound doctrine is particularly troublesome and dan- 
gerous in a country like the United States, because the majority of 
the people have the power to affect the policy of the government 
in economic matters, and frequently use that power. Accordingly 
one of the greatest tasks of the student of Economics is to train him- 
self in the art of detecting the fallacies which lurk in popular beliefs. 
This task confronts us, too, at the very outset of our course ; for some 
of the most wide-spread fallacies are concerned with facts already 
brought out in the foregoing general account of the present economic 



II] GENERAL SURVEY 31 

order. We will, therefore, at once set about formulating principles 
and applying them to popular errors. 

All Profit from the Efficiency of Each. — The first generaliza- 
tion from the nature of the present order which we have to lay down 
is that, generally speaking, each person gains from the increased 
efficiency of his neighbors. In one way this would seem to follow 
as an evident corollary from the proposition already set forth, that 
our economic order is cooperative. As long as we cooperate in pro- 
duction, the efficiency of the persons producing all the dififerent com- 
modities will increase ; this will swell the total product of the group 
and so may naturally be expected to bring advantage to all members 
of the group, those concerned with one commodity as well as those 
concerned with another. Thus, when the farmer, carpenter, and 
mechanic cooperate — in the sense that each specializes in his own 
craft and exchanges his product for those of the others — they every 
one obtain better goods and more goods and goods of a greater va- 
riety than they otherwise would. But in real life there is a more 
difficult problem. Suppose that, after cooperation is established, the 
farmer and the carpenter come to a standstill in the development of 
their craft, while the mechanic proceeds to acquire an extreme ef- 
ficiency. It might be argued that, although the aggregate product of 
the group will surely be increased, this will not necessarily be of any 
advantage to the other members of the group, because the increase 
may all go to the person whose efficiency has risen, the mechanic alone. 

The Proof. — The full answer to this objection depends on 
a knowledge of the principles of price or value which we do not take 
up till later in our study. Still, it will not be difficult to anticipate 
that discussion sufficiently to satisfy the student's mind in regard to 
the general point, (i) If the mechanics learn to make twenty cars 
a year instead of ten, while farmers and carpenters continue to pro- 
duce at the same rate as before, then under free competition the ex- 
changing rate between autos on the one hand and corn and houses 
on the other will alter in favor of the latter. For auto-makers, in 
competition, will offer more and more of their increased supply of 
cars against a supply of corn and houses that has not increased at all. 



32 PRINCIPLES OF ECONOMICS [II 

Accordingly, a certain quantity of corn and houses will buy more 
automobiles than before. (2) Since by hypothesis no change has 
taken place among the farmers and carpenters, the exchanging rate 
between their goods, corn and houses, will not have altered : a certain 
quantity of one will buy the same quantity of the other as before. 
(3) Consequently, the farmer or carpenter will find himself able to 
buy with his own product more automobiles, while buying no less 
houses or corn. In other words, he will have gained from the in- 
creased efficiency of another producer. 

It must not be imagined, of course, that the producer whose ef- 
ficiency increases derives no advantage from that increase. A man 
who suddenly runs far ahead of his fellows in efficiency may, before 
competition can overtake him, reap enormous gains; and the use of 
secret processes, and the protection of patents may for a brief time 
prolong this advantage. Besides, even when competition is operating 
freely, the efficient producer will commonly gain. Each unit of 
his commodity buys less than before; but he has more units to buy 
with, and usually this brings to him an increased total of other goods. 
The point to be emphasized here, however, is that, although the person 
or the class that shows increased efficiency may gain something by 
it, the public also does not fail to gain. The benefits of an improve- 
ment do not accrue permanently to the producer alone; they are 
diffused, they go to the public — and, broadly speaking, to every 
member of the public. 

Formulating the point brought out in the foregoing discussion, 
we have the following : 

Principle. The present order being a cooperative one, 
each person or community tends to gain from an increase in 
the economic efficiency of other persons or communities with 
whom or with which said person or community maintains 
economic relations. 

Real Functions of Trade. — A second matter on which we need 
thus early to lay down a formal principle is the function of trade, 
exchange. There is indeed almost no other phase of Economics on 



II] GENERAL SURVEY 33 

which popular opinions go so widely astray. In the minds of a few 
persons, all trade whatever is illegitimate; to a much larger number 
this is true of at least some kinds of trade ; and a majority of persons, 
probably, believe that trade, if legitimate at all, is surely in any 
proper sense of the word, unproductive. But if the account given in 
this chapter of the general features of the economic order is sound, 
all these adverse judgments are of course quite untenable. Trade in 
general, and presumably all kinds of trade, are legitimate because they 
play a vital, necessary role in economic affairs. Exchange is, as we 
have seen before, of the very essence of our heterogeneous coopera- 
tion — it both effects and regulates that cooperation — and the one 
without the other is unthinkable. The fact may, therefore, be for- 
mulated in the following: 

Principle. Under the existing economic system, ex- 
change {trade, commerce) plays an essential part in that it 
makes possible economic cooperation and specialisation — 
it supplies the process, or system of processes, whereby co- 
operation is effected and regulated. 

Furthermore, if we understand by the word "productive" that 
the operation so characterized fulfils a condition essential to the 
satisfying of our wants, then trade in some form, certainly, is pro- 
ductive. 

This proposition so plainly follows from the principle that 
it needs no further proof. It gives us two corollaries. The first 
concerns the function of exchange as effecting our cooperation and 
may be stated as follows : 

Corollary i. Exchange operations, viewed as processes 
necessary to consummating our economic cooperation, are 
productive operations, and people engaged in such operations 
are producers. 

The second corollary, though it follows quite as directly from 
the principle, may require some little comment. It concerns the 
fact that exchange is the regulator of our cooperation. Many persons 
who admit that mercantile operations are productive in so far as 



34 PRINCIPLES OF ECONOMICS [II 

they are devoted to buying from producers and selling to consumers, 
would yet be disposed to deny the productivity of these operations in 
so far as their function is the determining of prices. But the error 
of such a denial can readily be seen. As the principle tells us, ex- 
change is responsible for the proper regulation of our economic 
activities, and this part of its task is largely performed through the 
changing of price. It follows, then, that exchange operations, viewed 
merely as price-determining operations, are essential parts of the 
total productive process, hence, are productive operations. 

Corollary 2. Exchange operations, viewed as processes 
whereby our cooperation is regulated through price, are pro- 
ductive operations and persons engaged in such operations 
are producers. 

Illustrative Problems 

1. "Give the farmer a parcels post to begin with. Let him send his 
dozen eggs or his pair of chickens direct to the man who wants to eat 
them, or at least to the retail merchant. Cut out the commission mer- 
chant, the wholesaler, and a few other of the city parasites that live on 
the farmer." — New York Evening Journal. 

(a) Suppose yourself to be a farmer living in the neighborhood of 
Ann Arbor, and point out some advantages you would derive from selling 
your butter to the grocers and your chickens to the meat men rather than 
to consumers. 

(b) Suppose yourself to be a fruit grower in Western Michigan, de- 
pendent for your market chiefly on Chicago, and point out some dis- 
advantages which you would suffer if you tried to sell grapes, peaches, 
etc., by parcels post to the ultimate consumers in Chicago and its vicinity, 
rather than to commission merchants. 

(c) Show that these facts are inconsistent with the notion that com- 
mission merchants, wholesalers, et at., are "city parasites." 

Note : There is of course much to be said in favor of a parcels post ; 
and it is always possible that the number of middlemen should become 
needlessly large so that some of them may fairly be viewed as parasites. 
But such a characterization of the class as a whole is quite illegitimate. 

2. "Internal commerce does not increase the wealth of a nation since 
it only transfers goods from one person to another." Criticize. 



II] GENERAL SURVEY 35 

3. At various times there has been much talk about the "right price" 
for some commodity. On the basis of the account of the present order 
given in this chapter, what would be a natural definition of "right price" ? 

4. In the natural course of events it often happens that a country- 
loses some portion or the whole of its market in some particular country. 
When this happens or is anticipated, public men are apt to speak as if 
such a result involved almost irremediable disaster. Doubtless it would 
mean some loss, but by no means the amount which people seem to 
imagine. Explain precisely what would be the nature of the injury to 
us, if our foreign trade should fall off by a considerable amount. Sup- 
posing our foreign market showed a permanent net shrinkage of 200 mil- 
lions of dollars per annum, would this mean that our yearly income would 
be 200 millions smaller? If not, just what would it mean? 

5. From the Congressional Record for May 17, 1909: "Mr. Aldrich. 
Assuming that the price fixed by the reports is the correct one, if it 
costs 10 cents to produce a razor in Germany and 20 cents in the United 
States, it will require 100 per cent duty to equalize the conditions in the 
two countries. . . . And, so far as I am concerned, I shall have no hesi- 
tancy in voting for a duty which will equalize the conditions. . . . 

"If it was necessary to equalize the conditions, ... I would vote for 
300 per cent as cheerfully as I would for 50." 

To what sort of an economic system would such notions, if logically 
carried out, inevitably lead? 

6. "A first-class illustration of the absurdity and wrong of the pres- 
ent order is furnished by the case of a plumbing firm. Such a firm does 
little, if anything, more than act as a middleman between the actual 
plumbers and householders. But it pays the former at the rate of, say, 
30 cents an hour for their services, while it charges householders 60 
cents an hour for those services. Here you have a plain case. Either 
the firm underpays the laborers or overcharges the householders ; and 
in either case it gets something which it has no right to. There is no 
other alternative." Discuss the above. 

7. "If the wheat crop of the world should fall ofif one-half next year, 
a rise in price would then be of great social advantage." Explain. 

8. The general account of the existing economic order which has 
been given in the present chapter furnishes one of the most fundamental 
objections to the maintenance of a protective tariff, i.e., a tariff intended 
to hinder our buying goods from other countries. Explain that objection. 



CHAPTER III 

AUTHORITATIVE CONTROL IN THE EXISTING 
ECONOMIC ORDER 

We have thus far described the present economic order as built 
up and regulated by the free, spontaneous action of men. This 
description is, in the main, correct ; and it emphasizes the fact which 
we should first of all fix clearly in mind. There is an economic 
order of a perfectly definite sort, organized in a highly intricate way, 
and, in spite of its apparent surface contradictions, tending to supply 
man's wants with an efBciency truly marvelous to those who have 
never before reflected upon the fact; and this order, in its most 
essential features, owes its existence and its regulation to the free 
action of men pursuing their own personal economic interests. 

Not Purely Spontaneous. — In saying this, however, we by no 
means present a complete and accurate picture of the existing order. 
There never was, and is not now, an economic order purely spon- 
taneous. The spontaneous action of men in their economic relations 
has always been more or less influenced, either in the way of help or 
hindrance, by authoritative forces outside the men themselves. Some- 
times mere public opinion or a general social custom has made itself 
felt, Son;ietimes a powerful religious organization has said that men 
should do thus and so, and has compelled them to do it. But the 
strongest of all authoritative forces outside the individual, especially 
in the present age, is the action of organized government. To this 
aspect of the existing order, we must give something more than pass- 
ing attention. First, then, we comment briefly on some governmental 
activities which may be looked on as logically essential to the realiza- 
tion of the principle dominant in the present order. Later we will 
remark on several kinds of governmental activities which are more 
or less inconsistent with the central principle of our order, but which 
are, after all, by many or most authorities thought desirable. 

36 



Ill] AUTHORITATIVE CONTROL 37 



Activities Essential to the Realization of the Central Principle 
of the Present Order 

Free Initiative. — One type of governmental activity vi'tally 
essential to the present order insures the possession by a considerable 
number of persons of the right of free initiative. This proposition 
is immediately deducible from the fundamental character of the 
present order. That order, we remember, depends on the initiative, 
the spontaneous action, of the individual to see that the right things 
and the right quantities of things are produced ; and, at the same time, 
it expects individuals to exercise this function under conditions of 
competition. Naturally, then, it will be necessary for people gener- 
ally to possess the right of initiative. Further, since this right might 
easily be hampered by the voluntary action of other individuals, it is 
necessary that the state should make special provision to insure its 
maintenance. The government must, for example, do its utmost to 
eliminate what is known as monopoly, — the control by one will of 
economic activity, especially the production or sale of any kind of 
goods. 

Right of Property. — Again, governmental action is vitally 
needed to insure that individuals shall have the power to get control 
of the instruments of industry, the raw materials, tools, machines, 
etc., including the services of those human beings who assist in the 
productive process ; for, obviously, production cannot be initiated 
and carried forward by the spontaneous action of individuals, unless 
they have this power. Our present economic order, in some of its 
variations, has allowed full property in all these factors to the private 
individual. At times it has permitted him to own land, materials, 
tools, and even the human beings who give off productive services. 
In the present age, as we know, property in human beings is almost 
universally forbidden ; but in the other instruments of production it 
is almost as universally recognized. This private ownership is not 
strictly a necessity. The state might own the instruments while the 
men who initiate and maintain production merely buy from it the 



38 PRINCIPLES OF ECONOMICS [III 

services of those instruments ; and yet the fundamental principle of 
our order would be successfully carried out. In any case, however, 
it would be necessary that individuals should have the power named, — 
the power to control and dispose of these services — else they certainly 
could not initiate and guide economic activities. 

But not cnly does the present system require that individuals 
shall have the right to control instruments of production, it is 
possible that the right will be infringed by the action of other indi- 
viduals. Superior force or guile may greatly impair the efficiency of 
the system approved by the public will. It follows that governmental 
action is needed to insure the possession by the individual of these 
necessary property rights. Whatever degree of control over the 
instruments of production we purpose to grant to the individual, 
that control we must insure to him by governmental action. Simi- 
larly, the government should, of course, insure that the man 
responsible for the production of economic goods shall be secure in 
his right to the ownership of those goods after he has produced them. 
For other persons might be disposed and able to deprive him of the 
fruits of his efforts, thus destroying the motive for industry; and 
this possibility can be shut out only by the action of the government. 

Right of Contract. — Another type of governmental action 
essential to the conduct of the present order is the authorization and 
maintenance of contracts. Individuals must be permitted to make 
agreements with one another in respect to their economic conduct, 
and the government must provide for the enforcement of these agree- 
ments. This necessity grows out of two facts: (i) Many economic 
operations require extended periods of time, and (2) in many cases 
the carrying out of the time-consuming process requires a dependable 
anticipation of future needs. If a man is building a house, he will 
need material and labor at various times during a considerable period 
in the future ; and, for obtaining these, he cannot safely trust to the 
chance of the moment. To secure something like certainty, he makes 
contracts in advance. Again, as we all know, one of the chief factors 
in production, capital, is largely obtained by borrowing from others. 
And this involves a contract, in that the borrower must agree to 
return the sum borrowed and pay interest for its use. 



Ill] AUTHORITATIVE CONTROL 39 

But, if it is practically necessary to have a right of contract in 
carrying out the principle of the existing order, it is also necessary at 
this point to have some action of the government ; for, without gov- 
ernmental interference, the right of contract could not be effectively 
maintained. Circumstances would always be arising in which it was 
for the interest of one or the other of the parties to break the contract ; 
and all experience shows that the temptation is too powerful for 
human nature unless restrained by the strong hand of the law. Our 
economic system, therefore, requires that the government shall au- 
thorise and enforce contracts. 

Free Exchange. — Again, it is plain that governmental au- 
thority is needed to insure the right of free exchange. As we saw 
in the preceding chapter, one of the most central features of the 
present order is a type of cooperation effected and regulated through 
exchange. The existence of a general freedom of exchange is, there- 
fore, an absolute sine qua non. But this freedom is always liable to 
be infringed by the selfish action of other individuals. Dealers them- 
selves are eager to eliminate competition and often try to do so by 
agreements of a monopolistic character. The necessary freedom of 
exchange, then, can be insured only by the potent interference of gov- 
ernment. The state may conclude that for reasons of a public nature 
it is, on the whole, undesirable to maintain perfect freedom in every 
field ; but it should insure such freedom for economic action in gen- 
eral, and it should see that no interference with that freedom is 
permitted except what it authorises. 

Illustrative Problem 

Weak, tyrannical, or corrupt governments are each unfavorable to 
high economic efficiency. Why? 

II 

Activities Designed to Increase Economic Efficiency 

We come now to several forms of governmental activity which 
cannot be described as logically essential in carrying out the funda- 
mental principle of the present order. They usually involve limita- 
tions upon that principle. They have often been opposed by rigid 



40 



PRINCIPLES OF ECONOMICS [III 



supporters of the present order, but, in the course of the last century, 
have notably increased in all fields. Here we note, first those activities 
which attempt to improve the present order by supplementing indi- 
vidual action zvith more efficient governmental action. Not a few of 
this sort have been carried on by government in all ages, so that they 
are looked on by almost every one as belonging essentially to the 
governmental sphere, for example, the issue of the money which 
acts as a medium of exchange, the building of roads, or the making 
of canals. 

Another type of activity contributing to the efficiency of pro- 
duction which has greatly increased in our day, is the conduct of 
investigation into the conditions and methods of procedure necessary 
to highest technical efficiency. Thus public bureaus are maintained 
to carry on research in biological subjects, like the breeding and care 
of animals, the improvement of seed, the discovery of better condi- 
tions for growth, etc. An activity closely allied to this last is the 
dissemination of information among those engaged in an industry, 
most conspicuously those engaged in agriculture. Still another con- 
sists in providing for technical education and training through schools 
of agriculture, mining, manufacture, and commerce. 



Ill 

Activities Designed to Alter the Distribution of Property and 

Income 

It has always been recognized that the present system needs to be 
supplemented by governmental action not only to increase its ef- 
ficiency, but also to prevent undesirable consequences which the free 
working of the system would inevitably produce. One such con- 
sequence is extreme inequality in respect to the distribution of 
property and income. In spite of the high efficiency- of the system 
as a whole, many people feel that we cannot rest content until we 
have ameliorated the inequality resulting from it. And at this point 
the intervention of government is demanded. 

Among the various policies used by government to improve the 
system of distribution, we have the guidance of taxation in a way to 



Ill] AUTHORITATIVE CONTROL 41 

throw the chief burden on the weahhier classes. In other fields, a 
particular kind of service is sold to everyone at the same price, — 
the rich man and the poor man pay the same for a loaf of bread or a 
pound of meat. But, since the fundamental services supplied by 
government have no price to rich or poor vi^hile the cost of main- 
taining government falls more heavily on the rich, the latter virtually 
pay a higher price for these services than do the poor. In effect, 
then, the system of taxation redistributes the social income in favor 
of the poor. 

In speaking above of the attempt to relieve less wealthy people of 
the tax burden, we had in mind especially that volume of taxes which 
is bound to be levied because it is destined to meet the necessary 
expenses of government. A second method of diminishing inequality 
also involves the system of taxation, but in a different way. Govern- 
ment undertakes to improve the condition of people of small or mod- 
erate means by furnishing certain services and goods either gratui- 
tously or at a price lower than would appear under the operation of 
free private initiative ; and the funds needed to meet the expense for 
these types of activity, like the ordinary income of government, are 
raised by taxation, assessed according to wealth; so that the net 
result is a redistribution of income favorable to all but the wealthy 
classes. 

The most familiar example of this kind of governmental inter- 
ference is found in the field of education. Poor people lack money 
to give their children an education ; the state undertakes to provide it 
for them. In respect to the simpler forms of education, this policy 
dates back a long way; but in our day it has been extended also to 
the more advanced forms. Intermediate, and even the very highest 
cultural courses, as also technical or vocational training, are open to 
all classes, if not gratuitously, at least below cost. The children of 
the poor, as a result, have opportunities many times greater than they 
could expect in an order purely spontaneous. Supposing their 
natural endowment adequate, they may hope to attain the highest 
professional positions of all sorts.^ 



* The student is of course aware that much of this sort of work is done 
by the voluntary contributions of the rich; but we are here concerned only 
with the activity of government. 



42 PRINCIPLES OF ECONOMICS [III 

Another line of governmental activity concerned with bettering 
the condition of the poorer classes and so in effect redistributing the 
social income, looks after defectives, — the maimed, the blind, the 
insane, the feeble-minded — either in part or in vi^hole at public ex- 
pense. The wealthy could afford to provide for this themselves, the 
poor could not. Again, the government often manages certain in- 
dustries which furnish fundamental necessities such as water, gas, 
and electric current, in order to help the poor by supplying these at 
lower prices than would appear under private initiative. In Europe 
a number of municipalities have gone so far as to undertake the 
running of street car lines, charging fares, especially for working- 
men, below the cost of the service. Still again, governments improve 
the condition of the less well-to-do by maintaining institutions for 
supplying all classes with forms of entertainment which would natur- 
ally be open only to the rich. This is illustrated in the maintenance 
of free public libraries, picture galleries, opera houses, parks, and 
playgrounds. 

ILLUSTRATIVE PROBLEMS 

1. In what other way than that given on pages 41 and 42 can the 
governmental provision of education for the masses be justified? 

2. Argue that it would be better to use the method described on 
page 41 for promoting the welfare of the poorer classes rather than a 
method which tried to alter their incomes directly, that is, by raising the 
rate of wages. 

IV 

Activities Designed to Secure Some Advantage, of the Social 
Group as a Whole 

In the last section we dealt with activities designed to improve the 
condition of the poorer classes. All such activities may be and doubt- 
less are inspired in part by another motive, the desire to improve the 
condition of the group as a whole — ^the city, the state, the nation. 
For surely any group which hoped to prosper as a whole would see 
to it that taxes were levied with relatively less weight upon the poor, 
that defectives were cared for, and that education for all was pro- 



Ill] AUTHORITATIVE CONTROL 43 

vided. The foremost motive in all these activities, however, is 
perhaps the welfare of the classes or of the individuals who are 
directly aided. We come now, on the other hand, to a type of 
activity motivated mainly if not entirely by the desire to improve 
the welfare of the group as a whole; a type intended not to guard 
the individual, but to guard the group against the evils which might 
result from the unhindered working of the present system. It may 
be true, as has been implied in much of our earlier discussion, that 
for all individuals everywhere an absolutely spontaneous, automatic 
workings of things would be, on the whole, best. In that case a man 
whom we should describe as thoroughly cosmopolitan in spirit, one 
who is interested in all humanity, would find in such regulation the 
highest possible ideal. But this description applies to very few of us 
indeed. Oftentimes we are not interested in the welfare of indi- 
viduals everywhere, nor even in our own immediate welfare, or in 
that of people directly dependent upon us, so much as we are inter- 
ested in the success and greatness of the city, state, or nation to which 
we belong. Further, the welfare of an individual is not necessarily 
consistent with that of his group ; there is a possible antithesis be- 
tween the welfare of the individuals constituting a group and that of 
the group considered as a whole. Hence, if any group of men comes 
to believe that the free, automatic regulation of economic relations 
between their own group and other groups (although best for them 
as individuals and for all individuals everywhere) hinders the ac- 
complishment of some good greatly important for their own group, 
they will naturally insist upon interfering with this automatic regu- 
lation, and insist on resorting to conscious control through the power 
of the state. 

National Power and Independence. — The chief application of 
the idea jlust set forth arises in connection with the problem of 
maintaining the independence and power of the nation over against 
its neighbors. The efficiency of a state at this point manifestly de- 
pends on economic as well as on purely military considerations. A 
nation needs to be wealthy; it needs to have great capacity for the 
production of the instruments of war ; it needs to be insured the 
forthcoming of the fundamental necessities of life in case it should 



44 



PRINCIPLES OF ECONOMICS [III 



through the fortunes of war be cut off from its usual sources of 
supply. Now it is perfectly possible that the spontaneous working 
of economic forces should result in neglect in some of these fields. 
The natural resources of the nation may be chiefly agricultural; so 
that the unrestricted pursuit of private gain may hinder the nation 
from developing the manufacturing industries and so render it un- 
prepared to supply itself with the manufactured goods needed for 
war. On the other hand, it may naturally be an exclusively manu- 
facturing or commercial nation, obtaining its supplies of food from 
other countries. The pursuit of private gain may then fail to develop 
sufficiently some industry on which its very life depends. 

The possibility that unrestricted private initiative may thus ex- 
pose a nation to complete destruction if cut off by war from its 
ordinary sources of supply has led governments to put high taxes on 
the importation of foreign goods, thus raising their prices and so 
making more profitable the producing of similar goods at home. 
Legislation has been used, likewise, to develop important forms of 
manufacture ; so that we find almost all nations erecting tariff barriers 
to shut out the products of their neighbors and stimulate the home 
pursuit of the same industries. 

Interests of Posterity. — We have commented on those activi- 
ties of the state which are designed to protect a group as a whole 
against other groups by avoiding the economic weaknesses likely to 
result from individual action in economic matters. Another set of 
injuries growing out of individual liberty is associated with the dissi- 
pation of our primary resources in land, raw materials, etc. Ex- 
perience has shown that private self-interest cannot be trusted to 
conserve the stores of coal, iron ore, copper, oil, and timber which 
constitute, so to speak, the patrimony of the nation. It is essential, 
therefore, for the welfare of the nation as a whole, that government 
should step in with a policy of conservation, well planned and strictly 
enforced. Similar to this case, and even more important, is the 
conservation of the life, health, and strength of the people themselves. 
Unrestricted private freedom in business has meant an exploitation 
of the strength and capacity of working people, especially women 
and children, quite inconsistent with the welfare of the group as a 



Ill] AUTHORITATIVE CONTROL 45 

whole. As a consequence, there has developed through a century of 
agitation and legislation a great body of statutes designed to guard 
the productive population against the evil effects of excessive and 
unsuitable labor in unsanitary conditions. 

Summary. — To sum up the contents of this chapter: Upon 
the economic order described in the last chapter as one of cooperation 
automatically effected and regulated by exchange, we find at many 
points the influence of conscious regulation directed by government. 
Certain activities of government in enforcing the right of free initia- 
tive, private property, contract, and exchange, are necessary to allow 
the automatic principle to work itself out in any really effective 
manner. The government also acts at various points in contradiction 
of the principle, in order to increase our economic efficiency, or to 
better the economic condition of certain classes or to secure the 
safety and welfare of the nation as a whole. 

The emphasis we have put upon these modifications should not, 
however, lead us to overlook the fact that they are, after all, modifi- 
cations and that only. The great essentials of the economic -order at 
present existing are not these things but the things we described in 
the last chapter. The present order is in the main one in which, 
through the spontaneous action of the individual pursuing his immedi- 
ate self-interest, there arises cooperation of a highly advantageous 
sort, effected and regulated by exchange. It is that spontaneously 
developed organization or, better, organism, which constitutes the 
real framework of our system. And it is that organism which in the 
further study of this course we should keep most prominently in 
mind. 



CHAPTER IV 

ANALYSIS OF PRODUCTION 

The central fact of economics, as heretofore pointed out, and the 
starting point for all thinking on economic matters, is man's wants. 
These wants, as we have also seen, are supplied by things called 
economic goods, which take the form either of commodities or 
services. Now, a very little reflection will convince anyone that 
practically all economic goods become possessed of their capacity to 
satisfy wants through the action of men. Fish may grow in the sea 
and fur on the animal's back and trees in the forest ; but, strictly 
speaking, these objects do not become commodities suitable for appli- 
cation to our wants till they have been appropriated, shaped, or other- 
wise worked upon by forces directly manipulated by man. The same 
is even more obviously true of services, for in case of something like 
a lecture or a song, the very substance of the thing which gives 
satisfaction appears not to come into existence until the lecturer or 
singer puts forth his effort. This process of preparing goods for 
the satisfaction of wants is called production. Accordingly, since 
our wants are so urgent and since nearly all goods are necessarily so 
prepared, production must be recognized as one of the most important 
divisions of the study of Economics. 



What Is It to Produce? 

To begin with, what do we mean by the term "produce"? In 
everyday language, the word is used in several different senses, some 
of which are very broad, and some quite narrow ; and in the present 
study, we may at times allow ourselves a similar freedom. In the 
interests of clear exposition, however, it is best at the outset to adopt 
a meaning which we shall expect to have in mind when we speak, as 

46 



IV] ANALYSIS OF PRODUCTION 47 

economists, with the strictest scientific accuracy. Such a meaning 
may be expressed as follows : 

To produce is to make some contribution to the satisfying of 
human wants, whether this he done by persons or things, providing 
such contribution has a value or price. 

Two parts of this definition need a little emphasis : that the con- 
tribution made must assist in satisfying human wants, and that it 
must have a value or price — in other words, must have an economic 
character. In the light of previous discussions we shall need few 
words to justify the second of these qualifications. We are studying 
economics, not physical science. The sort of production we are 
concerned with is economic, not physical, production. But economics, 
as such, takes account only of those things which have value or 
price, and accordingly our definition of economic production is re- 
stricted to acts or conditions which have a price. 

Creates Only Utilities. — The first part of our definition will 
require more careful examination. Any valuable act or thing that 
makes a contribution to the satisfying of human wants is productive ; 
but what does it really mean to make such a contribution? Since 
wants are all supplied, in the last analysis, through material goods, 
it must mean to be responsible in some sense or degree for the exist- 
ence of material goods having the qualities essential for our satis- 
faction. But, to pursue the question further, how can a man be 
responsible for the existence of any material object of want-supplying 
qualities ? He cannot create the ultimate substance of an object, for 
all matter exists and always will exist in some form without his will 
or sanction. His contribution must, therefore, consist merely in 
bringing substances or materials which already exist into such a 
condition that they are capable of satisfying wants. Hence, since the 
capacity to satisfy wants is called Utility, we may say that to produce 
is to create utilities — the contributing act or thing being always un- 
derstood to have value. 

Kinds of Utility. — The emphasis laid on utility in the above 
analysis makes desirable some further comments on this term. First, 
as the word is employed by economists it includes many dififerent 



48 PRINCIPLES OF ECONOMICS [IV 

kinds of "fitness to satisfy wants." Thus, we have the fitness wlyich 
inheres, so to speak, in the economic object : an elementary utiHty, as 
for example in the mere substance of copper; and a form utility, 
illustrated when that copper has been drawn into wire and prepared 
for carrying an electric current. Besides this inherent fitness, we 
have the fitness which consists in the relations of the economic object 
to men. Thus a loaf of bread situated where it is wanted is more 
useful than an exactly similar one situated where it is not wanted, 
and accordingly the economist talks of place utility; ice which is 
preserved from the cold months when it is not wanted till the warm 
ones when it is wanted, assumes what we call a time utility; and a 
commodity passing from the hands of a person who has no need of 
it to those of one who does have such need, acquires an ownership 
utility. 

Again, it should be noted that utility includes all sorts of fitness 
to satisfy wants, without respect to the character of the wants. 
Thus, the fitness of coal to warm one is utility and the fitness of 
bread to nourish one ; but the fitness of diamonds to give one aesthetic 
enjoyment or even of whiskey to give vicious enjoyment is also 
utility — ^to the economist, diamonds and whiskey are just as truly 
useful as coal or bread. This of course does not mean that the 
economist holds different ideas from other people as to the relative 
importance of necessaries and luxuries or as to the undesirableness 
of using intoxicants. But in his terminology he must recognize the 
common element in diamonds, whiskey, bread and all other economic 
objects which fits them to satisfy human wants; and utility is the 
word which he has adopted for this purpose. 

Producer Does Not Create Value. — Another point to be noted 
before we leave this general topic, the meaning of "produce," is that 
producing should not be understood to mean creating value. Since 
it is the producing of wealth that we are talking about, and since 
wealth has value, it might seem that, to produce, one must be re- 
sponsible for the existence of value. But this is a mistake. The 
producer as such is not responsible for every element in wealth but 
only for the element of utility. His task is to do whatever needs to 
be done to insure that objects or conditions shall be fitted to satisfy 



IV] ANALYSIS OF PRODUCTION 49 

man's wants. Now, this must, of course, be done before the objects 
or conditions will have value. In doing it, therefore, the producer 
contributes to the process whereby value comes into existence. But 
he is not wholly responsible for the result. The existence of value 
requires the fulfilment of two conditions : ( i ) that the thing having 
value shall be useful and, therefore, wanted, and (2) that it shall, 
for one reason or another, be scarce, — limited in amount as compared 
with what is wanted. The productive process fulfils the first of 
these conditions. But, in so far as the fulfilment of the second de- 
pends on the productive process, it is the necessity for that process, 
not its carrying out, which does the work. Because we must produce 
things if they are to exist, because our capacity to do this is limited 
as compared to our wants, and probably, also, because production 
involves sacrifices, the amount is certain not to be adequate to the 
satisfying of all our wants. As a result the things produced are 
certain to have value. But this result the producer, per se, has not 
brought about. To the extent of his capacity and inclination, he has 
neutralised one of the conditions, namely, the scarcity of the product. 
And this is his function as a producer. His business is to give things 
the capacity to satisfy wants and so the capacity to call forth demand. 
That these things, after all, are scarce and so command a price is due 
to conditions not resulting from the productive act.^ Perhaps the 
most convincing argument on this point is that the producer could 
best contribute to the fulfilling of the scarcity condition of value by 
acts sharply opposed to the productive act, namely, by refraining 
from production or even by actually destroying goods. 

The Utilities Must Have Value. — Having emphasized in the 
preceding paragraph the point that we do not produce value, but only 
utilities, we must hasten to warn the student against a possible mis- 
understanding. The productive act as such is responsible for utilities 
only. Nevertheless, in the long run, every productive act which has 
an economic character must have a representative, an element corre- 
sponding to itself, in the value of the product. To illustrate, the 
raising of wheat requires land, sunshine, rain, seed, the labor of 



* We assume, however, that those conditions are fulfilled. See page 47. 



50 PRINCIPLES OF ECONOMICS [IV 

plowmen, and so on, many conditions and factors, of which factors 
some, Hke the sunshine or the rain, are not counted as economic at 
all, since they are outside human control or for some other reason do 
not have a price, while others, like labor, are economic, as clearly 
indicated by their having a price. And, in the case of the latter, it is 
quite certain that, in the long run, the price of wheat must be high 
enough to include an element representing the money spent for 
labor in producing that wheat ; otherwise, plainly, the farmer could 
not afford to pay for such labor. Nevertheless, the fact that, in the 
long run, there must be in the value of the product an element cor- 
responding to the contribution made by each factor does not justify us 
in describing that factor as producing that value. The factor pro- 
duces its special type of utility; the totality of economic conditions 
brings into existence the corresponding increment of value. 

Impute to Each His Immediate Product. — Another very im- 
portant point to be remarked under this head is that we should 
attribute to each producer the particular commodity (or the par- 
ticular service) for which he is immediately responsible. Thus, the 
farmer produces, not bread nor flour, but wheat. The miller 'produces 
not bread but flour. The employees of the miller produce not flour 
but services, which the miller combines with the services of various 
machines and wheat in such a way that he produces flour. 

Other Meanings. — ^The above discussion has brought out that 
meaning of production which is generally looked on by present-day 
economists as the most useful one. But, as remarked at the outset, 
we occasionally use the term in other senses, especially narrower 
ones, and we shall probably continue to do so. Thus, it is sometimes 
convenient to follow the popular usage which cuts off one class of 
producers from the rest, representing them as mediators between 
producers and consumers. I have in mind, of course, the exchanging 
class, who occupy a unique place in the system, in that they appear at 
every stage in the long chain of processes leading from the first-stage 
producers to the ultimate consumer, mediating between each member 
of the technical part of the series and his next neighbor. Thus they 



IV] ANALYSIS OF PRODUCTION 51 

act as go-betweens between the stock-raisers and the tanners; be- 
tween the tanners and the shoemakers ; between the shoemakers and 
the shoe wearers. Accordingly, we often find it convenient to use 
expressions Hke this: "It is the function of the exchanging class 
to correlate producers and consumers." That is, we sometimes use 
the term producers to include all sorts of contributors to the pro- 
duction of commodities and services except the exchanging class. 
No harm need result from this, if we remember that, in the deeper, 
larger sense, all who contribute in any kind or degree to the existence 
of utilities are producers. 

As a last comment under our present head, we add a word with 
respect to the scope of the economist's study of this topic, production. 
For it hardly need be said that the study of production undertaken by 
the economist is by no means exhaustive. Much the larger part of 
what might seem to belong under this head is commonly relegated to 
technical sciences or arts such as Engineering, Agriculture, and Me- 
chanics. Economics proper, especially the Principles of Economics, 
is primarily concerned with that particular aspect of goods which, as 
we noted in the first chapter, makes them economic, that is, value, 
though it is not entirely confined to this topic. When dealing with 
the physical, technical, side of economic goods — and production is 
mostly concerned with this side — we limit our study to certain most 
general aspects of the matter. 



Illustrative Problems 

1. The conception of "produce" held by the man who calls middle- 
men parasites is really the same as the one given in the text, though we 
emphatically deny his contention that middlemen are parasites. Defend 
that statement. 

2. "St. Thomas is not a producing island. Its importance consists 
in its position as a harbor of refuge and a coaling station, and as a place 
for refitting vessels." Show from the passage that St. Thomas is a pro- 
ducing island, as we understand the word. 

3. Have the playing cards of a gambler utility? Are they wealth? 
Has a diamond ring utility? 



52 



PRINCIPLES OF ECONOMICS [IV 



4. A man who is getting no income now but expects to have one 
six months from now borrows $100 from his neighbor, promising to pay 
back the $100 and $6 more at the end of a year. 

(a) Does the $6 represent any advantage — service — received by the 
borrower ? 

(b) If so, can the lender reasonably be credited with the production 
of that service? 

5. "Only miners, lumbermen, farmers, and such like ought to be 
called producers; for they are the only ones who add something to the 
total wealth. The rest merely change the form or relations of the things 
which the above-named produce." 

Show that there is no essential difference in the contributions of the 
farmer, the miller, the baker, the grocer, and the delivery man. 

6. "The Chinaman lives economically. He earns all he possibly can 
and saves it and takes it back to his native land. He is a very econom- 
ical consumer, and instead of being a wealth producer, acts as a leech 
upon the wealth of the nation, sucking in all that he can and taking it 
away to enrich the land of his ancestors." Criticize the part in italics. 

7. Mr, X hires the opera house for an evening and hires the Men- 
delssohn Quartette to give a concert in it, I pay 75 cents to hear the 
concert. 

(a) In precisely what does the wealth which I buy consist, the work 
of the singers, the pleasure I derive from the singing, or something else ? 

(b) Did the Quartette produce the wealth I bought, or something 
else? 

(c) If the Quartette did not, who did? 

8. "Thus there are today tens of thousands of lawyers, bankers, 
traders, middlemen, speculators, and others, whose functions, necessary 
to the capitalistic regime, would (under socialism) cease to have any 
value. They would be compelled because of this to enter the producing 
class." 

(a) Show from the quotation itself that, under a reasonable inter- 
pretation of the phrase "producing class," the groups of persons named 
are already in that class. 

(b) May the labors of these persons be productive now, although 
they would not be productive under socialism? Don't forget to explain. 

9. "Labor alone is the producer of wealth; take away labor and not 
all the capital in the world could produce anything." 



IV] ANALYSIS OF PRODUCTION 53 

Allowing the second clause to be true as a statement of fact, does it 
prove the proposition contained in the first? 

10. Accepting the conception of wealth given in this text, the con- 
ductor of a street car is a producer of wealth. 

(a) Just what form of wealth does he produce? 

(b) For whom does he produce it? 

(c) Who produces the wealth I buy when I ride in the cars? 

II 

Economic Factors of Production 

Factors in General. — It is obvious on the least reflection that 
to produce wealth or economic goods necessitates the combined opera- 
tion of difl'erent things, — different elements, forces, conditions. To 
raise potatoes, for example, we need a place on the land, suitable soil, 
labor, tools, sunlight, moisture, nitrogen from the air, and so on. 
Now, all these different things — ^these elements, forces, conditions, — 
we call factors of production. They include everything which con- 
tributes to the result attained; and their number is legion. For 
purposes of distinction, we usually refer to them as physical or 
technical factors. But not all of these factors belong to our study. 
A very considerable number of them we call non-economic, meaning 
that they are lacking in the characteristics which belong to all things 
economic. While all of them are useful, not to say necessary, to 
man, they are not appropriable, or are superabundant, or are given 
gratuitously by the government, or for some other reason fail to 
take on the property of value, especially pecuniary value, which is 
the distinguishing mark of economic things. Non-economic factors 
include the sunlight, moisture, and nitrogen, mentioned above, also 
the body of knowledge inherited from the past by each generation, 
the protection of government necessary to successful production, the 
many direct contributions of government to productive processes, the 
gratuitous advice and assistance of other persons not directly par- 
ticipating in a particular task, and many other things one could men- 
tion. Many of these non-economic factors are absolutely essential 
and so of a generic importance indefinitely great. But, in general, the 
economist gives them brief consideration because they do not belong 



54 



PRINCIPLES OF ECONOMICS [IV 



to his realm or belong to it only in a very limited sense. His study, 
therefore, is chiefly occupied with those factors of production which 
are strictly economic. 

Economic Factors. — The distinguishing characteristic of 
economic factors was noted above. Such factors have value, — in the 
present order, have exchange value, and that expressed in terms of 
money — pecuniary value."^ These economic factors are very numer- 
ous, including the land, the great variety of substances out of which 
or with the help of which man produces goods, and many different 
types of effort or sacrifice which man himself must undergo. In 
some important economic problems, we may as well at the outset 
recognize that the differences among factors are largely irreducible — 
that nothing is gained by treating them together. But, in many other 
connections, it is convenient, almost necessary, to group these factors 
into a few large classes. One of the most common methods of doing 
this recognizes three such classes : ( i ) materials, services, and instru- 
ments, coming from nature, for example, iron ore, standing room on 
the earth's surface, water power; (2) labor services supplied by 
man himself ; and (3) materials and services from instruments which 
have been produced to be used in further production, e.g., pig iron, 
the services given off by an engine. The various factors of the first 
group are usually designated by the one term land; those of the sec- 
ond by the word labor; and those of the third by the word capital. 
We will now make some more specific comments on each of these 
three types of factors. 

Land. — That land in the broad sense above noted is necessary 
to the producing of goods is too evident to need serious argument. 
Obviously nothing can be produced without having in it stuff, ma- 
terial ; and, since man cannot create substance, such stuff or material 
must come from nature. Things of this sort constitute the primary 
raw materials. Again, it is plain that we can do nothing without a 



^A particular factor might be an economic factor under the present order 
though it might be merely a technical factor under some other order. A 
shortage of supply is necessary to make anything an economic factor, and 
this may be produced artificially where the naturally abundant supply is 
under a single control. 



IV] ANALYSIS OF PRODUCTION 55 

place on which to work, locate buildings, machinery, etc. Still, again, 
the simplest agricultural operations require the activity of the biologi- 
cal forces; while getting needed power requires the assistance of the 
expansive force of gases or the power of moving air or falling water. 

But, though these various elements of natural origin are so mani- 
festly factors in production, not all which serve in this capacity are 
true economic factors. Thus, air, moisture, and sunlight, while neces- 
sary to production as physical or technical factors, are not controllable 
or appropriable, and therefore lack the element of value, — for which 
reason, they have no standing as economic factors. Again, position 
on the earth's surface, though appropriable, may fail of being counted 
as a true economic factor. In partially settled countries some of the 
land actually in use is no more desirable than much which is not in 
use; there are other waste pieces lying all about which could be 
substituted for the used piece with no decrease in the product, and 
at practically no expense. Now, because other land of its kind is 
so abundant, the particular piece first occupied will have no price. 
It will be a free good, like air or moisture, and so, according to our 
definition of "economic," will not be an economic factor. 

But, after all, comparatively few of nature's contributions can 
be disposed of in this way. While position on the earth is free in the 
wilderness, it is in settled communities very distinctly not free, be- 
cause, in proportion to the population, it has become scarce. Com- 
monly, then, land, as position on the earth's surface, — the original, 
unproducible, indestructible earth — is a true economic factor. No 
argument is needed to show that the same is often true of Primary 
Raw Materials, such as coal and iron in the earth and standing timber 
in the forest ; these also usually have value because relatively scarce, 
and so must be accounted. 

Some might, perhaps, object to the argument that land necessarily 
comes to have value and so comes to be an economic factor, in this 
wise. "All land was originally a free good, a gift of nature. That it 
now has value and, so, is an economic factor in the sense here used, 
is due to unjust laws which authorize private persons to own it, — 
make it their property." The unsoundness of this view is easily 
shown. Ownership is essential to the existence of exchange value; 
but such value cannot be given by ownership alone; there must be 



56 PRINCIPLES OF ECONOMICS [IV 

scarcity as well. If there is monopolistic ownership, to be sure, this 
scarcity itself may be secured artificially, and so the economic char- 
acter which the scarcity helps give to the land will be in so far 
arbitrary in nature. But the ownership of land is not usually monopo- 
listic ; there are many competing owners. It follows that the scarcity 
necessary to give land value — make it an economic factor — cannot be 
due to the fact that that land has become subject to ownership. Such 
scarcity, broadly speaking, is a natural condition, a condition arising, 
not from a policy which man deliberately adopts, but because the 
quantity and capacity of the elements furnished by nature are defi- 
nitely limited and prove to be inadequate to satisfy all man's needs. 
Even under socialism, land would have a natural value because of its 
natural scarcity, and for that reason would be an economic factor, 
just as truly as now ; only, the owner of the land would then be the 
state, and accordingly the contribution made by the land in production 
would be credited to the state rather than, as now, to private indi- 
viduals. We must conclude, therefore, that, wherever land is scarce 
relatively to need, it should be counted as one of the true economic 
factors of production. 

Labor. — ^Under this head we include all services contributing 
to the existence of commodities which have their origin in human 
effort. This should be understood as meaning not only labor in the 
popular sense of physical exertion, but also mental and nervous 
efforts of any sort — bookkeeping, managing, advertising, or pro- 
moting. It makes no difference how humble the effort or how high, 
it makes no difference whether the effort be directly applied to the 
materials out of which the good is being produced, or whether it 
be applied indirectly, as in the management of a concern or in service 
on the board of directors — ^that effort classifies in the economic sense 
as labor. 

That the functions thus performed by labor are essential to almost 
every kind of production, is too evident to need argument. Labor is, 
therefore, a factor in production, — a physical or technical factor. But 
it is no less certain that labor is also a true economic factor. It can- 
not be had for the asking ; it is scarce relatively to the need for it ; it 
has exchange value. 



IV] ANALYSIS OF PRODUCTION 



57 



Capital. — As indicated on page 54, capital is commonly defined 
by economists as being produced goods used to assist in further 
production. That such goods play a very important part in the 
productive process is surely evident. Almost all industries except the 
most primary ones work upon materials which have been produced 
as distinguished from the primary raw materials mentioned on page 
55. Again, almost every worker must have tools, instruments, which 
have to be produced. Still, again, we could accomplish but a tithe 
of what we now accomplish save for the help of great natural powers 
such as falling water; and these can be made available only by the 
help of elaborate constructions such as dams and water wheels. In 
turn, these powers can be utilised only through great machines which 
have to be produced. 

Again, capital, conceived in the way above indicated, that is, as 
consisting of a body of intermediate products, products devoted to 
producing other products, is not only an important factor in the 
productive process — it is also an economic factor. Such intermediate 
goods, machines, tools, materials, cannot be had gratuitously. We 
must pay for them, just as we have to pay for labor or for the use 
of land. 

This, however, is not the end of the matter. Capital, as thus con- 
ceived, is of course a factor in production and an economic factor. 
But, then, capital as thus conceived is nothing more than the land, 
labor, and previous capital entering into it; and, going back to the 
very beginning, it is nothing more than the land and labor entering 
into it. In other words, if this way of conceiving capital covers 
everything contained in it, we scarcely ought to talk about capital at 
all, but only about the capitalistic method of using land and labor. 
Still further, the natural place to make any needed comment on this 
special method of production would seem to be under the factors 
really involved, namely : land and labor. 

We naturally ask, then, why does not the economist pursue such 
a course? The answer is that the economist believes that, in some 
sense or degree, there is to be found in capital some element other 
than land and labor — ^that the use of the capitalistic method involves 
some condition which the land owner as such or the laborer as such 
cannot fulfil — an element which, therefore, makes capital into a factor 



58 PRINCIPLES OF ECONOMICS [IV 

other than mere land and labor. He further believes — better, perhaps, 
knows — that this element, as well as land and labor, has its price, and, 
therefore, is not only a factor, but also an economic factor. On the 
basis of the belief just indicated, he naturally sets about trying to 
find out just what it is that constitutes this distinctive element in 
capital, how it is brought into existence, what function it performs, 
and so on. The following chapter will be devoted to an attempt to 
cover in some measure these problems. 



CHAPTER V 

CAPITAL AS CAPITAL 

The close of the last chapter brought us to the point of conceiving 
capital as having in it some element additional to the land and 
labor which produced it, and therefore as, in some sense or degree, 
constituting a factor different from such land and labor. As such a 
different factor, it surely calls for a special treatment. We now un- 
dertake this task ; and since it is one of the most difficult in economic 
science, we shall have to ask for more than ordinary care and patience 
on the student's part. 

I 

Capital as Carrying-Power, Waiting-Power 

How the Problem Arises. — We will begin by setting before 
ourselves the general group of phenomena associated not only with 
production but also with our whole economic life, which are chiefly 
responsible for the existence of our present problem. Let us suppose 
that, because of some unparelleled catastrophe, the total population 
of a given modern community is instantly taken out of life, though 
everything else remains as before. Let us suppose, further, that an 
observant and intelligent visitor at the scene of destruction makes a 
rough inventory of all forms of products — produced wealth — to be 
found in the place. Doubtless as a result of his efforts there would 
present themselves a number of interesting and important groupings 
of these products ; but only one of these is especially significant for 
our present purposes. That one divides all the economic products 
into two groups as follows: (i) a small body of products and 
services of products ^ which, if the great catastrophe had not come, 
would have been devoted to the satisfying of immediate wants, and 
(2) a great body of products and services of products which would 



^ To be explained in a moment. 

59 



6o 



PRINCIPLES OF ECONOMICS 



[V 



not, and, generally speaking, could not, have been put to such im- 
mediate use, but would, instead, have been kept in reserve for the 
satisfying of future wants. These two groups we may perhaps 
advantageously designate as active goods and reserve goods, or im- 
mediate-service goods and future-service goods. 
They may also be distinguished as active goods 
and idle goods, though the latter designation is 
liable to cause misunderstanding. 

This distribution of the whole body of 
products and services of products belonging to 
our imaginary community, into active goods and 
reserve goods, is brought out in the accompanying 
diagram, Figure i. The lower, heavily-shaded 
portion of the rectangle represents the active 
goods of the community ; the upper lightly-shaded 
portion represents the idle or reserve goods. 
The marked difference in the size of the two 
portions brings out the point that our supposed 
visitor would find the active goods, immediate- 
service goods, constituting but a very small share 
of the total. 



Reserve Goods Indispensable. — The above 
account of the probable conditions of things in 
our hypothetical community has. obviously im- 
plied that such a condition is not at all abnormal, 
is in fact just the natural, usual condition. Such 
a relation between the quantities of idle and active goods as that 
indicated is bound to prevail in any community with a highly de- 
veloped industrial system. High efficiency requires that we spend 
a large share of our productive resources in maintaining a stock 
of the goods which are not to be used in the satisfying of immediate 
wants. Let us note some of the more important reasons why 
this is true. 




Figure i. Active 
and Reserve Goods 



Contingent Reserves. — Perhaps the case which displays this 
necessity in the purest form, with the least admixture of other ele- 



VI CAPITAL AS CAPITAL 6l 

ments, is to be found in what we may call contingent reserves, by 
which we mean reserves which are held to meet needs which cannot 
be precisely anticipated, needs which are more or less unexpected, 
contingent. Manifestly such reserves are practically indispensable 
in the case of many consumption goods. No one above the pauper 
class would think of trying to get along with only one collar or only 
one shirt or only one pair of socks, making it necessary to go without 
any while the one was being laundered. In like manner, we always 
have in the house more food than will be wanted for the next meal ; 
more fuel than will be wanted during the one day ; and so on. And 
one reason why this is necessary is suggested by the word "con- 
tingent" — such reserves are needed to meet situations which may 
arise unexpectedly, situations which, because they were unexpected, 
could not, without reserves, be provided for at all or only at much 
inconvenience.^ 

But contingent reserves are needed not only in consumption but 
also, and on a far larger scale, in production. The factory devoted 
to making shoes needs to keep stocks of leather, nails, thread, parts 
of machinery, shipping cases, etc., considerably in excess of pre- 
cisely ascertainable needs. Further, this does not merely apply 
to the things used in the productive process; the factory must also 
keep contingent reserves of the product itself — its own product. It 
could not afford to be content with a stock just sufficient to meet the 
demands of the moment, since these could not be calculated in ad- 
vance. Nor could it be content with a stock j-ust equal to the average 
demand, since there would be variations above this average as well 
as below. This is still more conspicuously true for the shop which 
deals in the shoes of our factory, since the dealer has not the power 
possessed by the manufacturer, through his control of plant, ma- 
chinery, and labor, of speeding up the process by which shoes are 
turned out. 

This case of contingent reserves is graphically presented in Figure 
2. The shaded rectangle at the left represents the amount of a par- 
ticular product which the manager considers necessary to provide for 



Doubtless there are other reasons for keeping such reserves beside this 
contingent element; but contingent reserves give us a case which is theo- 
retically of much importance. 



62 



PRINCIPLES OF FXONOMICS 



[V 



the possible needs of the period of stocking-up customary in his line, — 
a week or a month or whatever it may be. The portion of this total 
which in all probability will actually be used during that period is 
represented by the larger of the two sections into which this rectangle 
is divided by the horizontal line. In the first compartment of the 
enclosed space, we have the state of things at the end of the first 
period. The larger portion of the stock has been utilized, as is shown 
by its appearing heavily shaded in the space between the two hori- 




1924 



1925 



1926 



192 



1 



Figure 2. Contingent Reserves 

zontal lines below. But, even when this has been done, a portion still 
remains in the lightly shaded rectangle above. This, of course, is the 
reserve. In the second compartment, the management is represented 
as' renewing the stock to its first level by purchase outside or by 
production within (the bent arrow from above indicating this opera- 
tion). As before, the productive processes of this period use up 
what is needed (indicated by the appearance below of the heavily 
shaded square) ; and, as before, a surplus or reserve substantially the 
same in amount as the preceding remains intact. And, obviously, this 
course of things must go on indefinitely. 



V] CAPITAL AS CAPITAL , 63 

The Periodicity of Nature. — We have noted the particular 
reason for the maintenance of stocks of idle goods, reserves, which 
grows out of our inability to anticipate our needs with absolute pre- 
cision, — a fact which leads us ,to designate reserves of this type 
contingent reserves. But there are many other conditions making 
the maintenance of reserves in one sense or another very necessary. 
Notable among these is the periodicity of nature in respect to her 
productive processes. Thus practically all kinds of crops mature 
only at certain seasons of the year. This compels us, in the case of 
almost any farm product, to provide for the total needs of any 
year during a few weeks or months of that year ; and this in turn 
means that during much of the year we must be maintaining reserve 
stocks of such products far in excess of immediate needs. 

Installment-Service Goods. — A much more important reason 
why we have to maintain reserves of goods or their services than 
any yet mentioned is to be found in the fact that efficiency in produc- 
tion requires us to make use of many produced goods, tools, machines, 
buildings, etc., which give off their services only in stages, little by 
little — installment-service goods we may call them. Thus take the 
case of a farm tractor which, for the sake of simplicity, we will sup- 
pose to last in full efficiency for a period of five years and then all 
at once become useless. Such a machine must be thought of as a 
bundle of services measured most naturally in some time unit, say a 
year or a quarter or a month. By having control of the tractor for 
any such interval, we are able to accomplish much work of various 
sorts. The first quarter it gives off one installment of possible 
service, the second quarter another installment, the third another, and 
so on ; and manifestly we could get the benefit of these services only 
as they were given off. That is, during the first quarter we could 
utilise but one- service. But, now, though we could enjoy only one 
service during this quarter, we should have to have on hand the whole 
outfit of such services tied up in a tractor lasting five years, that is, 
twenty in all ; for such a tractor can be made only as a whole. It 
follows that during the three months which pass while we are getting 
the first installment of the tractor's services, we should lijrje to keep 
in idleness the remaining nineteen; while we were utilizing the second 



64 



PRINCIPLES OF ECONOMICS 



[V 



1924 

rrr 



1925 
"Tl 



installment, we should have to keep in idleness the remaining eight- 
een ; and so on. This is brought out in Figure 3, The tractor ready 
for use at the end of 1923 is represented by the vertical rectangle 
at the extreme left; the divisions of this rectangle made by 

the incomplete partitions represent the 
twenty installments of three-months 
services which the tractor is supposed to 
give off during its lifetime. In the first 
quarter of 1924, the first installment is 
used up, as is shown by its transfer to 
the space between the horizontal lines 
below, while the nineteen unused install- 
ments remain above, showing that, 
though unused, they have to be "car- 
ried," In the second quarter, the second 
installment is used up and so passes into 
the space below, leaving eighteen idle 
installments to be carried. And so on. 

But it is hardly necessary to say that 
the life history of a single tractor does 
not fully cover the situation. By hypoth- 
esis, our tractor lasts but five years, 
and therefore must be replaced if this 
system of production is to go on. Con- 
sequently, while the twenty services 
bound up in the first tractor, are being 
utilized, we must be making another 
bundle of tractor services, that is, another tractor, to take the place of 
the first when the twentieth service is used up. It follows that the 
employment of this method of production requires the continuous 
maintenance of a fund of twenty idle services of tractors partly 
derived from the old tractor, partly from the new.' This is brought 
out in Figure 4. In this we have side by side eight columns, each 



Figure 3.- Installment 
Service Goods A 



^ Understood literally, this of course applies only to the community taken 
as a whole. The farmer does not set about making another tractor little by 
little, but accumulates during the lifetime of the first tractor the sum of 
money necessary to buy a second one made by some one else. 



V] 



CAPITAL AS CAPITAL 



65 



containing twenty divisions representing twenty different tractor 
services of three months each. The first contains nineteen belonging 
to the original tractor — lightly shaded — and one belonging to the new ; 
the second column shows eighteen services 
of the old and two of the new; the third, 
seventeen of the old and three of the new; 
and so on. 



1924 



TTT 



1925 




Many-Stage Goods. — The last reason 
we shall mention why efficiency in pro- 
duction requires that we should maintain 
a large stock of reserve goods is to be 
found in the fact that the materials out of 
which many commodities are made, those 
intermediate products which eventually 
emerge as final products, have to pass 
through several or many different pre- 
liminary stages, and, while actually in any 
one of these, cannot be utilized in the 
satisfying of wants — while passing through 
these ' stages, they are merely to-be goods, 
inchoate goods, goods in the making. Thus 
the shoes which I wear must have been 
first skin on the body of some animal, then 
hide in process of tanning, then leather at 
the shoe factory, then finally shoes. Up 

to the last stage, they plainly must have been reserve goods — idle 
goods, from the standpoint of the satisfying of immediate wants. 

This point is illustrated in Figure 5. The product chosen is 
some rapidly growing tree, say a catalpa, which matures sufficiently 
for making fence posts in, let us say, five years. The square in the 
upper left corner represents a plantation of these trees started at the 
beginning of 1924 ; at the beginning of 1925 we move it down into 
the second compartment, indicating that it has advanced a one-year 
stage toward the status of a matured product; the beginning of 
1926 finds it in the third stage ; and by 1929 it is ready for utiliza- 
tion. Obviously, this productive procedure necessitates maintain- 



Figure 4. Installment 
Service Goods B 



66 



PRINCIPLES OF ECONOMICS 



[V 



ing every year a fund of idle wealth represented by one of the 
squares. 

But here, again, our statement is quite incomplete. If this sys- 
tem of production is to go on continuously, we must have, in addi- 
tion to the plantation of catalpas started in 1924 to provide product 



'24 



'25 



'26 



'27 



'28 



'29 









Figure 5. Inchoate Goods A 



for 1929, a second plantation started in 1925 to supply product for 
1930, a third started in 1926 to supply product for 1931, and so on. 
That is, once the system is fully established, we must maintain each 
year, not one, but five plantations, one in each stage of growth. This 
is illustrated in Figure 6. The plantations of every other year are 
shaded more lightly than the intermediate ones to make them easily 
distinguishable ; but the total after 1928 is in each case five planta- 
tions. 

The preceding discussion has made it plain that the condition 
of things with respect to products supposed to prevail in our 



V] 



CAPITAL AS CAPITAL 



67 



imaginary community is absolutely necessary to the existence of any 
highly efficient economic system : in addition to the goods destined 
for the satisfying of immediate needs, we must maintain an enormous 
fund of goods which, from the standpoint of the present, are idle 
goods, useless goods, goods which are not satisfying any wants of 
ours. It is, indeed, true that each individual unit of such goods 
will sooner or later be utilized to satisfy wants ; but by that time 
each must have a substitute to replace it, so that the fund, the total, 



'24 


'25 


'26 


'27 


'28 


'29 


'30 


'31 


'3 






















Figure 6. Inchoate Goods B 

of such idle, useless, goods remains the same constantly. Looked 
at as a fund, those goods are never utilized, are always in reserve, 
always idle. 



Problems Involved. — The explanations of the last five or six 
pages have been primarily devoted to setting before the student 
those phenomena involved in the production of economic goods which 
lead the economist to add, to the list of factors necessary to pro- 
duction, one which he calls capital. In doing this, however, we 
have more or less anticipated the solution of the deeper problems 
which these phenomena suggest. Those problems are chiefly: (i) 



68 PRINCIPLES OF ECONOMICS [V 

Does the necessity for a fund of reserve goods involve the recogni- 
tion of a new factor, a factor additional to labor and land? (2) if 
so, what is the precise function of that new factor? and (3) is the 
factor thus isolated an economic factor as well as a technical one? 

Capital an Independent Factor. — The first of these problems 
is one of great difficulty, and there is not as yet general agreement 
with respect to the proper answer. That capital cannot be looked 
on as wholly a new factor is a proposition which would probably 
gain general assent. Since the goods making up the reserve fund 
on which we have laid such emphasis are products, they must be 
produced, as mere physical objects, in just the same way as other 
products, that is, by the use of all the factors necessary and so, 
of course, by labor and land, as well as by capital, if there is such 
a thing. It follows that, looked at in one way, those goods are 
merely embodiments of these antecedent factors and, therefore, to 
a considerable extent are merely "congealed labor and land." Our 
first problem, therefore, resolves itself into this: Is so-called capital 
only congealed labor and land? Put affirmatively: Is there not in 
capital, or in the method of production which employs capital, an 
element which, in some sense or other, is different from, additional 
to, labor and land? Probably most economists would agree that the 
correct answer to this question in its second form must be an 
affirmative one, — ^there is an element in capital different from, addi- 
tion to, labor and land ; the chief difficulty is found in determining 
upon the best method of establishing the point and in ascertaining 
precisely what constitutes this additional element. 

Decisive Proof. — The consideration w^hich, in the opinion of 
the writer, furnishes a decisive proof of the contention that capital 
or, anyhow, the employment of the capitalistic method, involves an 
element additional to labor and land, is to be found in a fact of 
business returns familiar to everyone. That fact is that the returns 
from any business must be great enough so that the person re- 
sponsible for owning, "carrying," the reserve goods necessary in that 
business will get, in addition to the amount necessary to replace 
those goods in so far as they are consumed in the productive process, 



V] 



CAPITAL AS CAPITAL 



69 



something more, a surplus, a residuum. To illustrate, if a firm 
has $40,000 tied up in the reserve goods of its business, and puts 
into its annual output of product $30,000 worth of goods and 
services from these reserve goods, it must get out of the business, 
not only the $30,000 necessary to cover this outgo, but also some- 
thing additional, say $2,400.* Now, since the $30,000 is adequate 



'24 



'25 



'26 



'27 



'28 



'29 




V////7A 

7/ 






Figure 7. Return to Capital as Capital 

to cover the concrete capital consumed, the $2,400 in excess of that 
sum must represent some feature, some peculiarity, of capital or 
the capitalistic method different from, additional to, labor and land. 
The point just made is given graphic illustration in Figure 7. 
The diagram there appearing is the value analogue of the illustra- 
tion represented in Figure 5. The latter diagram, it will be recalled. 



* In fact, there will need to be a residuum greater than this to cover the 
contribution of still another factor, or another contribution of this same 
factor, capital. This will appear in a moment. 



70 PRINCIPLES OF ECONOMICS [V 

represents the development of a catalpa plantation which, only 
after a period of five years, is sufficiently matured to satisfy im- 
mediate wants. But the development there represented is physical. 
The square, which is found a step further down each year than it 
was the preceding year,- — the plantation having moved each year a 
stage nearer maturity,— represents this plantation merely as a physical 
product. But in actual life there will be a value development as 
well. Even if we suppose the plantation to need no labor of any 
kind after the setting out of the first year; even if we suppose 
that the land used is a free good, so that no allowance has to be 
made in the value of the product for the contribution of the land; 
nevertheless five years must elapse in order that we may get the 
benefit of nature's gratuitous contribution to the fitness of these 
trees to satisfy human wants. Because we must keep, say, $i,ooo 
worth of wealth tied up in this plantation for these five years, the 
product has to show, and in actual life will show, an increment of 
value each year. Accordingly, in Figure 7, the plantation is repre- 
sented, after the first year, not by a series of equal squares, but by 
a series of rectangles increasing in area each year. With each of 
the rectangles the portion below the horizontal line represents the 
addition to value which, as experience shows, is bound to come 
with each succeeding year. 

The fact that there is such an addition to value shows that there 
is something about the capitalistic method of production — some con- 
dition of its employment — which we have not yet clearly isolated. 
For, in the long run, the value of products cannot be greater than 
the value of all the elements entering into their production.^ It 
follows that, if we find an unexplained element in the value of 
products, we may be quite sure that there is a corresponding factor 
which, though not yet isolated, is necessary to the producing of that 
product. Now the increment of value here considered is just such 
an unexplained element. It cannot be explained as corresponding 



"This does not involve deciding whether the value of factors is deter- 
mined by that of product or vice versa. Whatever be the true course of 
causation, there can be no doubt that, generally speaking, the value of product 
and that of all the factors must show a close correspondence; so that, if 
the value of product is greater than that of the factors hitherto enumerated, 
this must be because some other factor has been overlooked. 



V] CAPITAL AS CAPITAL 71 

to the labor element in the product; for, by hypothesis, there is no 
labor put in after the first year and this is represented by the original 
square appearing under the year 1924. Again this increment of 
value cannot be explained as corresponding to the contribution of 
nature in developing the trees toward that maturity which fits them 
to satisfy man's need; for, by hypothesis, nature, land, is in our 
example a free good, has no economic character, — no more requires 
value in the product than does the sunshine or the rain. The fact, 
then, that such an increment of value is bound to appear surely 
shows that there is something about the capitalistic method of pro- 
duction which constitutes a factor in production different from, 
additional to, labor and land. 

Capital as Capital. — We have seen that, though capital is 
largely the embodiment of our two original factors, labor and land, 
there is something connected with it, or anyhow with the capitalistic 
process as a whole, which constitutes a factor in production addi- 
tional to labor and land. But obviously this limits the "otherness" 
of capital to some one phase or aspect of that capital or of the 
capitalistic process. In talking of capital with only this special 
phase or aspect of the matter in mind, I shall designate it, ''capital 
as capital/' in contrast with what we often call capital goods or 
concrete capital, meaning by the latter the actual concrete products 
which constitute that capital. But, having showed that we must recog- 
nize the existence of something about capital which gives to it 
independence, we have still to answer the question: What is that 
something ? 

Function of Capital as Capital. — Perhaps the most natural way 
to attempt the answer is to ask: What is the function involved in 
capitalistic methods which is not performed by labor or land? 
Understood in the most immediate sense, this question has been 
answered by anticipation in our account of the phenomena char- 
acteristic of a capitalistic economic order. If we are to employ 
the methods which mark such an order, we must maintain a great 
volume of products wJiich are in reserve, — which, from the stand- 
point of the present, are of no use to us. But, manifestly, the power 



72 PRINCIPLES OF ECONOMICS [V 

to do this does not come as a matter of course. Not every person, 
not even every community, can do it. These reserve products must 
draw on our limited productive capacities just as truly as do the 
goods devoted to giving immediate service ; and, each for each, they 
cannot be as important as the latter, just because they have to do 
with wants which are only possible^ as over against wants which 
are already actual. It follows that, generally speaking, we can 
employ methods of production which involve maintaining reserves 
only on condition that we have capacities to produce which can be 
spared from the service of the present; which, in turn, requires 
that we should, generally speaking, have accumulated a surplus of 
the products which we have been accustomed to look upon as essential 
and so can afford to turn our capacities to the production of reserve 
goods ; which, finally, requires that we should have saved, practiced 
abstinence, in order to accumulate such a surplus. Emphasizing the 
first and most immediate of the three conditions named, we say : 
The capitalistic method can be employed only on condition that some 
person has been brought into a position which enables him to own, 
"carry" the reserve products constituting the concrete capital of the 
community. We may affirm, therefore, that the distinctive function 
of capital as capital is to otvn or carry the concrete reserve products 
of the community. Since in the majority of cases this function in- 
volves "waiting," putting an interval of time between our productive 
efforts and the possession of product, there is much to be said in 
favor of the contention that waiting is the true function of capital as 
capital ; and we shall often employ such language. 

Distinctive Peculiarity of Capital. — Having isolated the dis- 
tinctive function of capital as capital, we are in a position to isolate 
the precise peculiarity about capital which marks it off as something 
different from the two original factors, labor and land. That 
peculiarity is the fact that capital as a fund of goods represents, 
indicates, embodies, the power of the persons who are the actual 
or virtual owners of those goods, to occupy this position, — the power 
to be owners. From this standpoint, capital as capital might be 
defined as owning or "carrying" power. If, on the other hand, we 
stress the point of view which sees in "waiting" the distinctive func- 



V] CAPITAL AS CAPITAL 73 

tion of capital as capital, we may define that concept as ^'waiting- 
power/' I shall not hesitate to employ this phrase as a synonym 
or substitute for owning power.'' Going a step deeper to the first 
condition lying behind the power to own or "carry" reserve goods, 
we may say that the distinctive peculiarity about capital is the fact 
that, looked at as a mere fund of goods in general, wealth, it is a 
surplus, a superfluity, a something in excess of the needs of the 
immediate present. 

Definition of Capital as Capital. — It follows from the above 
account of the peculiarity which makes capital a factor independent 
of labor and land that "capital as capital" may be defined as the 
fund of reserve goods conceived as being a fund of wealth, economic 
goods in general, in surplus, in excess of immediate needs. It, of 
course, has no existence independently of those goods : it is merely 
those goods looked at in one special way. Obviously, it is an ab- 
straction. But so is every concept an abstraction. When we think 
of the passengers in the rear seat of the automobile as making the 
machine ride more steadily, we are making an abstraction ; for, of 
course, these persons are not merely ballast to our car, but also 
human beings, who love and hate, have joys and sorrows, eat and 
sleep, work and rest, and so on, — who, in short, can be looked at, 
thought of, in a vast variety of ways besides that one which for 
the moment is of interest to us, that is, their serving to steady the 
car. Abstractions are not unreal things, but merely the real looked 
at in a limited way, with others of its various aspects ignored. 

Capital as Capital an Economic Factor. — In noting on pages 
67-68 the problems which the capitalistic method of production in- 
volves, we enumerated a third, in addition to the two which have just 
been considered, namely : whether the element which we have isolated 
as a factor additional to labor and land is also an economic factor. 
This question, however, was necessarily answered by implication 
when we established the reality of some not yet isolated factor by 

*I do not believe, however, that the word waiting can properly be 
substituted for "saving" as expressing the process by which capital comes 
into existence. 



74 PRINCIPLES OF ECONOMICS [V 

showing that there is in the product, and so of necessity in the pro- 
ductive process, a value element unaccounted for ; since, as was 
brought out earlier, the possession of value is the most characteristic 
feature of an economic, as distinguished from a non-economic, 
factor. It is not necessary, therefore, to show that the factor which 
we have isolated as additional to labor and land is an economic one. 
On this point, there is no room for difference of opinion. 

A diagrammatic illustration of the theory here presented as to 
the distinctive office of capital as capital is given in Figure 8. Let 
us suppose that the large oval in the upper compartment of Figure 8 
represents a certain quantity of labor, while the heavily shaded 
rectangle connected with that oval by the arrow pointing from 
left to right represents the amount of some product ready for 
consumption which that amount of labor could produce by a direct, 
non-capitalistic process, and without appreciable passage of time. 
In contrast, suppose that the two small ovals in the same compart- 
ment represent each one-half of the original amount of labor ; that 
the first half is devoted to making an intermediate product which is 
then combined with the second half of the labor in producing the 
same kind of consumption product as before ; that, when our original 
stock of labor is used on this second plan, the output of consump- 
tion product is forty per cent larger than when that labor is used on 
the direct plan ; and that in this case, as in the preceding one, there 
is no appreciable passage of time. Since, by hypothesis, the time 
required is negligible in both cases, there is obviously no reason why 
we should not choose the second more efficient method, — the round- 
about method, we call it, — and of course we should do so. Such 
roundabout methods would be universally employed; the whole 
product would be credited to the labor used; and there would be 
no thought of trying to isolate this other factor which we call "capital 
as capital." 

But it is hardy necessary to say that, in most cases of round- 
about production, the facts are quite different : such methods not 
only bring a great increase in product, they also usually require 
periods of time which decidedly are appreciable, while the periods 
required in direct production are almost negligible. Thus during the 



V] 



CAPITAL AS CAPITAL 



75 



harvest season, at any rate, the dweller in a sparsely settled district 
can have fruit to consume which he has gathered but a moment 
before. If, in contrast, he sets out to provide for his needs in this 
direction by the indirect process, — starting a berry patch or an 
orchard, bringing it to maturity, then enjoying the crop, — he must 
be content to put several or even many years between the beginning 
of the process and its final fruition. In our figure, the situation 



1924 



1925 



1926 




/; ; ; I I f I I j, J, 







-t ; j j. I li ; ^ I 



\t 



Figure 8. Capital as Waiting "Carrying" Power A 



thus brought about is represented by the diagram in the lower com- 
partment, in which the roundabout process presented in the upper 
compartment as not requiring time is represented as taking two 
full years. The fact that this new situation makes it necessary that 
producers should be provided with "carrying" power, waiting power, 
is indicated by the two horizonal brackets which bridge the two 
intervals of one year each. Just as the horizontal arrow going 
from the first labor oval to the lightly shaded square and, in turn, 
the arrow going from this square and the second oval of labor to 
the heavily shaded rectangle, indicate their participation in the pro- 



1^ 



PRINCIPLES OF ECONOMICS 



[V 



ductive processes, so the little vertical arrows dropping down to 
the long widening arrows which terminate in the intermediate and 
final product indicate the participation in 
the productive process of capital as capital, 
owning power, carrying power, waiting 
power. 

The above method of bringing out our 
doctrine as to the function of capital as 
capital, when applied to the whole body of 
products belonging to a community, appears 
in Figure 9. Here we have the same two 
rectangles which appear in Figure i ; this 
time however, the large, lightly shaded 
rectangle representing the fund of reserve 
goods, is inclosed in a frame having a ring 
at the top, for hanging upon a hook above. 
This symbolizes the function of capital in 
carrying, owning, upholding the fund of 
reserve, or immediately speaking, idle 
wealth which is necessary to the high ec- 
onomic efficiency of the community.'^ 

Illustrative Problems 
I. Suppose that the rectangle in Figure 
3 represents a dwelling house which will 
last just 20 years and so will give off twenty 
services of a year's duration each, and that 
each division of the rectangle represents one 
of these twenty annual services. What would 
be the function of capital in connection with such a dwelling? Give 
some reason suggested by our previous discussions why a family that 
was expecting to live in Ann Arbor for four years would prefer to rent 
such a house rather than to buy it. What is a person who rents such a 
dwelling for four years virtually doing? 

2. Josiah Wright, the wagon maker, is making a lumber wagon 
which he expects to sell to some neighboring farmer. Now, a wagon 




Figure 9. Capital as 

Waiting "Carrying" 

Power B 



^ For some differences in the way of conceiving capital and in the exten- 
sion given the term, see Note i of the Appendix. 



V] CAPITAL AS CAPITAL 77 

is undoubtedly capital or capital goods; yet in making that wagon, 
Wright is not, strictly speaking, producing capital. Explain the riddle. 
Show that Wright for various reasons needs to have capital himself in 
order to be a producer of wagons. 

3. "The socialist contention that producing with the aid of capital, 
as contrasted with producing without such aid, is merely employing our 
labor and land in a different way, though suggesting a point which is 
correct, is after all inadequate." Defend that statement. 

4. In an economic society like that of today, new capital quite 
naturally appears first in the form of accumulations of money or bank 
credit. Argue in support of that statement. 

II 
Capital as Responsibility-Taking Power 

We have thus far recognized only three classes of factors the 
operation of which conditions the existence of practically any and 
every economic product. With these three, economists usually stop. 
But there has emerged more or less clearly an implicit recognition 
of a fourth factor,^ namely, assuming the responsibility of produc- 
tion — willing that production shall go on. That this is an essential 
condition is obvious. Failure to isolate it in setting forth the different 
factors is, perhaps, due to the fact that under simple industrial 
conditions it is too intimately associated with one or more of the 
other factors. That the farmer who uses his land, labor, and capital 
to raise wheat must will to raise wheat is too evident to need com- 
ment, — indeed, it is involved in saying that he so uses them. Is it 
not, then, a mere fantastic refinement of theory to separate this 
function in the total process from the rest? The reason for a 
negative answer is not far to seek. The plain fact is that the more 
or less complete separation of the responsibility-taking function 
from the other functions involved in production, instead of being 
a mere refinement of the theorist, is characteristic of actual industrial 
practice. The men who are responsible for the producing of the 
vast majority of goods and services, outside agricultural products, 



It seldom appears explicitly in discussing the factors of production. 



78 PRINCIPLES OF ECONOMICS [V 

rarely own the land which they use, perform little or no labor them- 
selves, and own only a part, anyhow, of the capital employed in the 
business. This would seem to establish pretty conclusively the claim 
of this function to be a separate one in the productive process, — ^to 
be a fourth factor in production. 

Responsibility-Taking Belongs to Capital. — It must not, how- 
ever, be overlooked that, under the present order, this function, 
though plainly distinguishable from the three before discussed, is 
after all necessarily connected with one of the factors already treated, 
namely, capital. The man who assumes the responsibility of willing 
that production shall go on either must himself supply the capital 
needed, or must have other property with which to insure the 
capitalists from whom he borrows; since, otherwise, not he but 
they would assume the responsibility. In other words, the function 
under consideration may be conceived as one of two capitalistic 
functions, — the two being (i) the "carrying" of the reserves (wait- 
ing) and (2) responsibility-taking. In any case, our general point 
is evident enough : the function described is very real, is absolutely 
necessary, and is easily distinguishable from the one which we have 
recognized as peculiarly the capitalistic function, that is, "carrying" 
the reserves. We shall, therefore, recognize it as a fourth factor 
in production without further effort to define its precise relation to 
capital in the narrower sense. 

An Economic Factor. — The above discussion makes it clear 
that assuming the responsibility of production is a factor in pro- 
duction, — something without which production cannot go on. But it 
is also an economic factor; for it commands a price. The men 
who perform this service must, generally speaking, receive a profit 
in return for their services. 

Scope of This Function. — This function of responsibility- 
taking, which we have just isolated, involves making the general 
decision to produce in the field chosen, the bearing of anxiety, the 
assumption of various kinds of risk, and a limited amount of man- 
aging, — so much as is incapable of delegation to persons working 



V] CAPITAL AS CAPITAL 79 

for hire. Such a function is plainly the most vital and central 
in the whole productive process. Nature provides material ; labor 
provides power to rearrange the material ; capital provides carrying 
power, enabling these materials to be arranged by a roundabout 
process ; yet, though all these were present, no product could come 
into existence without the willing that the required rearrangement 
of material should take place. The will-to-produce is the productive 
factor par excellence. All other factors contributing to a business 
are naturally conceived as auxiliary to this ; their services are assem- 
bled and combined through the will-to-produce; and out of the will- 
to-produce emerges directly that commodity which is the product of 
the business taken as a whole. 



Illustrative Problems 

1. "Discovery and invention have doubtless played a very large part 
in securing our present high industrial efficiency. But they are not the 
whole thing. The increase of capital has been equally necessary; for, 
without capital, invention could have accomplished little or nothing." 
Defend and illustrate the last sentence. 

2. "The common pursuit of forestry as a private business almost 
had to wait until capital became relatively very abundant." Why should 
this be true of forestry more than of wheat raising? 

3. The following is taken from a short story in a recent number of 
one of the popular magazines. The hero inherited great wealth in roll- 
ing mills and has for several years successfully continued the business. 
He is also public-spirited and liberal. Referring to his charities, the 
author says : 

"What was it that he had given ? Something that he . . . had never 
earned. His hands had never touched belt or pulley. He looked at them 
curiously. It was the toil-hardened hands of twelve hundred other men 
that made his giving possible — the hands of the men he was planning to 
turn ofiF on Monday." 

Show that, if this was a normal case, we could impute to the services 
of the twelve hundred workmen only a part of the net output of the 
mills; that the portion going to the proprietor was reasonably enough 
credited to his contribution to the business. Enumerate several elements 
which probably entered into his contribution. 



8o PRINCIPLES OF ECONOMICS [V 

4. "The most of us live by our wits— spend our time wheedling the 
true producers, the men who work with their hands, into sharing with 
us the things which they produce." 

Give several illustrations of kinds of labor necessary to production 
which would not naturally be described as working with one's hands. 

5. Some writers have been disposed to affirm that, in the last analysis, 
all capital gets its start in a surplus of the means of subsistence, par- 
ticularly food. This undoubtedly has considerable force as applied to 
primitive conditions. Illustrate the proposition for a community of 
fishermen. 



CHAPTER VI 

THE DIFFERENT AGENTS IN PRODUCTION 

The preceding discussion has dealt with the fundamental or 
primary factors employed in productive processes. But, obviously, 
the control of these several factors must be in the hands of human 
beings, else they would not be economic factors. Accordingly, we 
are able to name a class of producers, of human agents in production 
corresponding to each of tJie different factors. This classification has 
already been anticipated ; but a more explicit reference seems de- 
sirable. 

The Laborer. — ^The agent in production corresponding to the 
first factor is, of course, the laborer, — ^the human individual who 
furnishes services which are the product of his own effort. It makes 
no difference whether the services are of physical or intellectual char- 
acter ; it makes no difference whether they are of the humblest 
sort, or of the greatest and most conspicuous, the man who furnishes 
them is a laborer. Promoting is labor, and managing is labor, as 
we have seen ; and the promoter and the manager are therefore 
laborers; the $100,000 president of a corporation is a laborer as 
truly as his office boy or the mason building his walls or the 
machinist in his shops. 

The Landlord. — Just as the laborer is the human agent in 
production corresponding to the element or factor called labor, so 
the agent corresponding to the factor called land is the land owner 
or landlord. The landlord is the individual who furnishes for pro- 
ductive purposes the use of land or land services. It is possible, 
as we conceded in the preceding section, to have an economic order 
in which land owning is not permitted, and therefore one in which 
this agent of production is not represented by any private individual. 



82 PRINCIPLES OF ECONOMICS [VI 

But it is not now possible, nor has it been possible since the very 
beginning of society, to have an order in which there was not some 
sort of landlord present as an agent in production. At the first 
moment any part of the existing land comes to be wanted by more 
than one person, at that moment it acquires value, and takes on the 
character of an economic good. Someone then inevitably appro- 
priates it in order to reap the advantage of its superior desirableness ; 
this someone may be an individual person or the -community as a 
whole ; but, whether one or the other, we will certainly have to 
secure his participation before we can utilize the land as a factor 
in production. Such was the course of events in early societies, 
and such will always be their course. Undoubtedly we can if we 
like substitute public for private landlords ; but the landlord is still a 
necessary agent in production, and we can never get rid of him. 

In saying that a landlord is present in every productive act, we 
do not of course mean to imply that he always exists as a distinct 
person. The land factor, as we have pointed out, is a different thing 
in its nature and in its contribution from the labor factor. But 
this is not to say that the land and labor cannot be controlled simul- 
taneously by the same person. On the contrary, it is very common 
for the laborer to furnish his own land and for the landlord to 
perform his own labor — a perfect example being that of a farmer 
or gardener who tills the soil he himself owns. Nevertheless, in 
admitting the presence of the two agents in the same person, we 
by no means reduce the two agents to one. To the extent that a 
man labors, he is a laborer, just as if he owned not a foot of land; 
and, for all the land he furnishes, he is a landlord, just as if he 
performed no labor whatever. 

The Capitalist Proper. — The third agent in production is the 
capitalist, the individual who owns, "carries," the reserve goods of 
the community. The capitalist does not labor ; he does not furnish 
land ; he does not assume the responsibility of making the business 
go ; and, generally speaking, he does not even put at risk his prin- 
cipal or the income therefrom. As capitalist, he simply supplies 
the surplus which constitutes the carrying power or waiting power 
necessary to make possible the use of roundabout methods of pro- 



VI] THE DIFFERENT AGENTS IN PRODUCTION 83 

duction. The use of "capitalist" in this definition is highly tech- 
nical, and subject in some degree to the charge of arbitrariness. 
But it is no more so than the best of the others which we might 
adopt; and, because of its practical utility in the further analysis 
of our subject, we shall regard it as correct. 

It is hardly necessary to remark that the same person may be a 
capitalist, a landlord, and a laborer. Men who own buildings and 
machinery very frequently own the land upon which they operate, 
and also, as laborers, attend to the operation of these intermediate 
goods. The farmer is the most obvious of many examples of a man 
who is capitalist, landlord, and laborer in one. 

But, while we recognize the possibility of a coalescing of the 
different agents into one, the emphasis, especially as regards the 
capitalist and the laborer, should perhaps be placed on a contrary 
tendency. In a state of primitive industry, laborers almost uni- 
versally own their tools, and men who own tools are also the wielders 
of them. But modern conditions of production tend more and more 
to separate the two agents. The amount of capital required for 
a modern business undertaking is very great, the carrying of a 
single machine, which a single laborer can operate, often repre- 
senting the tying up of thousands of dollars of purchasing power. 
The ordinary laborer cannot by any effort of saving accumulate a 
great enough fund of money to engage in this sort of production, 
and accordingly the saving is and must be done by other people 
who perhaps perform little labor in the ordinary sense. And even 
when laborers do save something from their incomes, the accumula- 
tions seldom make them masters of the particular tools they use. 
Their money is deposited in a bank, and, by a process to which we 
shall give more attention later on, establishes them as part capitalists 
in concerns other than those where they are employed, and usually 
in concerns of which they have no knowledge. 

But, even if there were no such tendency as the one just de- 
scribed, even if the three agents existed usually in the same in- 
dividual, this fact would not, in our logical analysis, reduce the 
three agents to one. In so far as a man labors he is a laborer ; in 
so far as he furnishes land, he is landlord ; in so far as he furnishes 
carrying power, he is a capitalist. 



84 PRINCIPLES OF ECONOMICS [VI 

The Entrepreneur. — The primary, central factor in produc- 
tion is responsibiUty-taking ; hence the primary, central agent in pro- 
duction is the person, natural or legal, who supplies this factor. 
Adam Smith (1776) called this person the undertaker, a designa- 
tion now out of vogue. Recently some writers have taken to using 
a newly-coined term, enterpriser. But most writers using the 
English language nowadays employ the French equivalent of Adam 
Smith's term, the word "Entrepreneur." 

The Entrepreneur is the agent who assumes responsibility in 
productive undertakings. If our analysis of economic factors has 
been understood, little further exposition will be required at this 
point. The entrepreneur is not a laborer but an employer of labor ; 
he is not a landlord, but a renter of land ; he is not capitalist, but 
a borrower of capital. He rents from the landlord, borrows from 
the capitalist, and hires a body of laborers ; and, marshaling together 
the elements obtained from these, he institutes production. 

Function of Entrepreneur Complex. — It should be remarked, 
however, that the division of functions cannot be so precise in the 
case of the entrepreneur as in that of any other agent. Even as 
entrepreneur, he cannot divest himself of functions which, from 
their nature, seem to belong to labor or capital. It is true that most 
of the labor furnished by some entrepreneurs could usually be per- 
formed quite as well by laborers they could hire. In respect to 
labor of this sort, therefore, the entrepreneur is merely a laborer. 
But certain duties he can escape only by ceasing to be an entrepre- 
neur, for example, appointing the higher director or managers of 
the business, and making certain final decisions with respect to the 
conduct of the business. These acts constitute labor as we ordinarily 
understand it, the putting forth of personal effort. Yet the entre- 
preneur does not therefore classify as a laborer ; for these acts 
cannot be performed by a true laborer, but are inseparable from his 
functioning as entrepreneur; in performing them he is not less, but 
rather more, of an entrepreneur. A similar complication arises in 
the furnishing of capital. An entrepreneur may and usually does 
put some of his own capital into a business. With respect to that 
capital, he may be thought of as both capitalist and entrepreneur. 



VI] THE DIFFERENT AGENTS IN PRODUCTION 85 

By means of it, he is in part furnishing the service of waiting 
necessary to the conduct of the business. He, therefore, credits to 
himself interest on this capital just as he would pay it to a lender. 
But the same capital serves in part as the basis of his power to 
perform his distinctive office as entrepreneur, that is, assuming 
the responsibility and risk of production. He, therefore, expects the 
entrepreneur's remuneration on this capital, in addition to the in- 
terest he receives on it as a mere capitalist. In other words, in 
respect to that portion of the capital which he himself supplies, he 
is both capitalist and entrepreneur, and gets pay for both types of 
service.^ 



Corporate Entrepreneurs. — It is sometimes necessary to dis- 
tinguish different kinds of entrepreneurs, namely, the individual and 
the collective entrepreneur. The term, individual entrepreneur, as 
an entrepreneur existing in a single person, sufficiently defines it- 
self. The collective entrepreneur may exist in any one of the legal 
business entities such as the Partnership, the Joint Stock Company, or 
the Corporation. 

In the case of industries undertaken by corporations, the cor- 
poration as such, the collective unit, is from the standpoint of 
formal logic the true entrepreneur. But cautious interpretation is 
here necessary. The corporation, acting through its usual organs, 
the president, the secretary, and general manager, cannot be the 
entrepreneur, because these organs are created by a more fundamental 
power, the board of directors. Again, the corporation acting through 
the board of directors cannot be the real entrepreneur, because that 
body is created by a power still more fundamental, the general meet- 
ing of stockholders. When at last we reach the general body of 
'stockholders, acting in the way prescribed by their charter for the 
decision of vital questions, we are in the presence of something 



^ In this analysis, if the entrepreneur gets fifteen per cent on the invest- 
ment, five or six of this must be reckoned as interest, only the remainder 
as true profits. In practical business, it is more usual to think of the whole 
fifteen per cent as profits, though most business men would at once admit the 
theoretic propriety of dividing that fifteen per cent into different parts : true 
interest and true profits. 



86. PRINCIPLES OF ECONOMICS [VI 

which may fairly be called ultimate, — there is nothing behind to de- 
termine its action. This general body of stockholders, therefore, 
should probably be recognized as the true claimant for the title and 
functions of entrepreneur. In some respects, on the other hand, 
the stockholders as a mere aggregate of individuals seem best to 
deserve the title ; particularly since the starting of a corporate under- 
taking, determining whether or not the industry shall be carried 
on at all — the taking of ultimate responsibility for production — 
rests with investors as individuals, not with the body of stockholders 
formally organized. Accordingly, for some purposes we have to 
locate the entrepreneur of a corporation in the stockholders formally 
organized, while for other purposes we must recognize this agent 
in the mere aggregate of stockholders. 

Functions of Different Agents Combined. — Finally, we must 
say of the entrepreneur what we have said of all the other agents, 
that he does not necessarily exist apart as a separate individual, 
natural or legal. Illustrations will at once occur of men who are 
entrepreneur, capitalist, landlord and laborer all in one. In fact, 
there probably never is in the real world any such complete separa- 
tion and specialization of the different agents as might be suggested 
by the foregoing analysis. But, in any case, the point already 
much emphasized must be remembered, that, even where all agents 
exist in a single person, they are logically distinct, because their 
functions are distinct. As a laborer, the man labors ; as a landlord, 
he furnishes land; as a capitalist he furnishes waiting power; and 
as an entrepreneur he furnishes responsibility-taking, an element 
which includes a small residuum of labor and waiting. 



The Entrepreneur the Producer. — To conclude this discussion 
let us repeat what has before been clearly hinted at, regarding the 
relation of the different agents. The cooperation of all the agents 
is required in practically all productive undertakings; and, since 
there are no degrees in necessity, it would be incorrect to say that 
one is more necessary than the others. Nevertheless, the last agent 
discussed, the entrepreneur, does stand in a peculiarly significant 



VI] THE DIFFERENT AGENTS IN PRODUCTION 87 

relation to all the others and to the product. In a sense, he merely 
employs the other agents as his auxiliaries, and he is responsible 
for the product. Hence, in the ordinary way of thinking, we 
esteem him as more important than the other agents. In recogni- 
tion of this judgment we shall call the entrepreneur the producer 
par excellence, and where "producer" is used in the later pages of 
this volume without qualification, it will be an entrepreneur whom 
we have in mind. 

Illustrative Problems 

1. "In cooperative production (meaning production in which the 
workmen own the business) the place of the entrepreneur is taken by a 
manager elected by the workmen." — Textbook. Criticize. How is the 
entrepreneur constituted in cooperative production? 

2. "Today, all over the land, masons, hod carriers, carpenters, and so 
on, are building palaces which other people are to live in. When so- 
cialism triumphs, all this will be changed. The worker, no longer robbed 
of the fruits of his labor, will himself occupy the palaces he builds, 
wear the broadcloth he makes, and eat the choice viands he produces." 

(a) Does justice require that the worker should have the right to 
consume the particular object he expends effort on? Explain. 

(b) If it did, would the particular set of workers — masons, hod 
carriers, carpenters, and so on — who construct the palace have the ex- 
clusive right to enjoy it? Explain. 

(c) Show that other persons besides "workers" in the sense here 
used have supplied conditions necessary to the existence of the palace. 

3. Until recently it was usual to teach that the peculiar function of 
the entrepreneur is to manage, direct, industry. One feature of modern 
industrial organization almost compels us to reject this idea. Explain. 

4. "Postponing consumption so that production may be carried on in 
a roundabout way is the function of the capitalist." — Textbook. Ex- 
plain and illustrate. 

5. Why do we say that every stockholder of a corporation is an 
element in the corporate entrepreneur while a bondholder, who also has 
capital in the concern, is not? 

6. Not many years ago Mr. W, after some months of painstaking 
negotiations, induced a number of persons owning certain lands on the 



88 PRINCIPLES OF ECONOMICS [VI 

Copper Range to join with him in organizing a corporation to build a 
railroad, open mines, etc., — Mr. W putting in some land of his own. 
For his fee, Mr. W was to receive a certain number of shares in the 
stock of the company. 

Distinguish, with explanations, the two economic roles played by Mr. 
W in this matter. 



CHAPTER VII 

GENERAL CONDITIONS OF PRODUCTIVE ' 
EFFICIENCY 

Production, as we have seen in the preceding chapter, is accom- 
plished by the united action of several different factors. Pro- 
ductive efficiency, the subject of the present chapter, means a con- 
dition or state of economic production in which the employment of 
a given quantity of these different factors results in a relatively large 
or desirable product. 

That a high degree of efficiency should be maintained is, of 
course, directly to the interest of the entrepreneur in charge of 
any industrial enterprise. But it is also to the interest of every 
person in the community. By the very first principle, formulated 
in Chapter II, every person (or community) in a cooperative order 
such as ours, tends to gain from any increase in the economic effi- 
ciency of other persons or communities with which economic rela- 
tions are maintained; and, directly or indirectly, every person in 
our system maintains such relations with every other person. 
Doubtless the extent to which individuals profit personally from 
such efficiency is subject to great variation; but we can scarcely con- 
ceive of anyone so situated that he would not gain something. 
It becomes pertinent therefore to make some inquiry into the laws 
and principles under which production may attain, and remain in, 
a state of high efficiency. 

At the outset of this inquiry, however, it should be noted that 
Economics does not attempt an exhaustive investigation into the 
technical conditions of productive efficiency. In its study of agri- 
culture, for example, it does not concern itself directly with fertiliza- 
tion, drainage, and rotation; nor, in its study of manufacturing, 
does it touch upon power generation, the choice and placing of 
machinery, and the like. These problems lie rather within the 
special province of the technical arts themselves ; they are problems 

89 



90 PRINCIPLES OF ECONOMICS [VII 

of agriculture and manufacturing, not of Economics. The field of 
Economics lies deeper. It embraces the more general principles 
which underlie and govern the purely technical phenomena of all 
the arts alike. Let us begin with a broad survey of these prin- 
ciples, and continue with a more particular examination of some 
of them in their relation to the different economic factors. 

I 
Capitalistic Methods 

One clearly established principle is that industries can usually 
increase their productive efficiency by the introduction of methods 
which employ a large amount of capital. Methods using some 
capital are probably without exception better than methods using 
none; and, as a rule, methods using much are better than those 
using little. 

In our day practically all production is capitalistic. There are 
to be sure marked differences in the degree to which capitalism is 
carried in various industries. Some industries, from their very 
nature, seem able to use more capital than others located in the 
same city or country ; and the industries in one city or country may, 
in general, use more than those in another. But, however great 
these variations, the fact remains that most industries can use all 
the capital available, and the more they use the higher is the pro- 
ductive efficiency to which they attain. 

Utilize Natural Powers. — The principal explanation of this 
increase in efficiency is to be found in the fact that, through the 
roundabout method, men are able to reinforce their own powers 
with the powers of nature, and thus to rearrange the materials upon 
which they work with relatively greater speed and precision. In 
the beginnings of industry, when the primitive fisherman, for ex- 
ample, made a net and a boat to use in catching fish instead of 
depending on his naked hands alone, the gain in efficiency was 
enormous; and even in later stages of industrial development some 
invention like the steam engine, the dynamo, or the cotton gin, gives 
to our productive efficiency an increas^ startlingly great. These 



VII] PRODUCTIVE EFFICIENCY 91 

facts would seem to be so familiar as to need little comment. Still 
they are not infrequently overlooked in times of popular excitement; 
and legislative measures are adopted and enforced which discourage 
the accumulation of capital or drive it out of the community. It 
was needful, therefore, that the point should receive some em- 
phasis. 

II 

Specialization 

We saw in Chapter II that the present economic order is one of 
heterogeneous cooperation, wherein each person specializes ; and 
that each individual in the system finds this specialization advan- 
tageous because it enables him to enjoy more goods and a greater 
variety of goods, and goods of better quality than he possibly could 
if he attempted to produce everything for himself. Now, of course, 
the primary reason why specialization enables the consumer to con- 
sume more and better goods is that it enables the producer to pro- 
duce more and better goods. We have thus already clearly implied 
that specialization is one chief source of productive efficiency. Let 
us now consider this point a moment from the producer's standpoint 
as we formerly did from the consumer's. 

Utilizes All Agents. — In the first place, specialization utilizes 
all agents and instruments of production, even the inferior ones. 
It splits up our complex industrial processes, dividing the small 
tasks from the great ; so that a person who cannot perform a whole 
process, because he is incapable of doing the difficult part of it, 
may neverth^ess contribute something to the whole because he is 
capable of doing the easy part. Thus a boy who would be quite 
helpless as the manager, machinist, or salesman of a concern, may 
make himself very useful running errands. On the other hand, 
specialization utilizes superior instruments and agents most fully. 
A steam locomotive designed for pulling forty of fifty loaded 
freight cars across the country at thirty miles an hour is kept 
constantly moving in that service, while lighter trains in the terminal 
are handled by locomotives of smaller power ; a skilful surgeon 



92 PRINCIPLES OF ECONOMICS [VII 

need not trifle away his time at mowing the lawn or going to the 
newspaper office for his paper — he can abandon those tasks to 
inferior agents and devote all his skill to dangerous operations in 
the hospital. 

Utilizes Aptitudes, Natural or Acquired. — Specialization 
utilises natural aptitudes, especially in the land and labor factors. 
A man endowed with a mechanical genius is kept busy at mechanics, 
instead of being required to cultivate corn ; and land that will raise 
fifty bushels of wheat to the acre is reserved for that valuable 
product instead of being given up in part to forestry or grazing. 
Specialization also permits the development, in the labor and capital 
factors, of artificial aptitudes. A pianist can greatly improve the 
flexibility of his hands, and consequently his skill as a player, from 
the fact that he is permitted to refrain from heavy manual labor 
and spend long hours at finger exercises on the keyboard. About 
the only implement the primitive man possessed was the knotted 
stick, and he could use it to destroy his enemies, to grind his corn, 
to pillow his head at night, and for numberless other purposes. But, 
viewed from the modern standpoint, the implement was not well 
adapted to any of those purposes; and specialization has given us 
thousands of different implements, creating in each a special apti- 
tude for one kind of work. Again, specialization economises in 
time for men and machines, since it eliminates the loss, often very 
large in the aggregate, of changing from one task to another. It 
also shortens the period of apprenticeship or education — a man can 
learn to be a skilful mason more quickly than he can learn to be 
both a mason and a carpenter. Finally, specialization stimulates 
invention — a man devoting himself completely to one particular job 
and learning all the niceties of it will find more ways of improving 
his performance than a man working now here, now there, on a 
dozen different jobs. 

Use Depends on Extent of Market. — We have just seen that 
specialization contributes greatly to productive efficiency. It fol- 
lows that the full realization of any condition requisite to such 
specialization must contribute to productive efficiency. Now, as 



VII] PRODUCTIVE EFFICIENCY 



93 



pointed out at the very beginning of our study, one such condition 
is exchange. Under the present system, specialization and the co- 
operation it involves is made possible chiefly through exchange. 
That is, in order to take advantage of the principle that specializa- 
tion increases efficiency, we must exchange products with one an- 
other. It follows that the degree to which this specializing can be 
carried depends on the extent of our exchanging. If we trade with 
only a few people, the need for a single kind of goods will be too 
small to justify any one of us in producing that kind only. Thus, 
the man who calls himself a barber in a small town can do most 
of the barbering which his neighbors require at night and on 
Saturday afternoon; and the rest of the time he must fill in as he 
can, mending shoes, soldering tin pans, or lending a hand on odd 
jobs at the garage. He cannot specialize in barbering, or in any one 
of his other trades, because the amount of service wanted by the 
community with which he exchanges is not large enough to keep him 
busy. Hence we have the following: 

Principle. The extent to which productive efficiency can 
be increased by means of specialisation varies directly as the 
extent of the market. 

Freedom of Trade Desirable. — The foregoing principle sug- 
gests one of the chief reasons why economists as a class are free- 
traders. They favor the utmost possible freedom from restrictions 
because this allows the largest amount of cooperation and thereby 
enables everyone to benefit most completely by the productive ac- 
tivity of everyone else. All economists, of course, would admit 
that free trade in some commodities is more important than in 
others, just because trade of any sort in some commodities is more 
important than in others. An import duty on hay would for some 
years not affect us one way or another — it would be a mere futility, 
since we do not normally buy much hay outside our own country. 
In contrast with this case, any departure from freedom in steel 
goods, textiles, and sugar is sure to have notable results, because 
we naturally import those things in large amounts. But, whether we 
deal in a commodity much or little, the privilege of trading with- 



94 PRINCIPLES OF ECONOMICS [VII 

out restrictions when we see an advantage will conduce to the pro- 
ductive efficiency of all the countries concerned. Hence the follow- 
ing corollary : 

Corollary. High productive efficiency depends on a 
large amount of freedom, of trade. 

Illustrative Problems 

1. "Our very large output enables us to make each man a specialist 
in his line of work." — Willard Storage Battery Company. Why? 

2. In most economic textbooks, one meets the phrase "geographical 
division of labor." 

(a) What do you suppose it means? 

(b) Give some illustrations of it. 

3. Give some examples of recently developed labor specialization, — 
if possible from your own observation. 

4. Same as Problem 3 for capital. 

5. Why is it that a country store keeps a little of everything, while 
a city store very often deals in only one kind of commodity, e. g., shoes or 
china or sporting goods? 

6. It is sometimes said that nowadays almost everything is produced 
for a world market. 

(a) What is one of the greatest gains of having such a market? 

(b) What are some of the most important industrial changes which 
have made it possible? 

(c) Suggest one or two of the most serious evils which would 
naturally result from it. 

Ill 

Large Scale Production 

It is a fact familiar to all of us that the extraordinary industrial 
progress of the last hundred years, and particularly of the last 
twenty-five years, has been accompanied by a great expansion in the 
scale on which industry is conducted. On the one side, the total 
output of commodities has greatly increased, their quality has, in 
general, been improved, and their price lowered — so that today 



VII] PRODUCTIVE EFFICIENCY 



95 



men who are considered poor may enjoy comforts which a hundred 
years ago would have been envied by kings. On the other side, 
we find that the estabHshments which produce these commodities 
are not so numerous as they were twenty-five or fifty years ago, 
but that the individual establishments now producing are in size, 
as compared to the old ones, very much larger. These two phe- 
nomena, it is generally recognized, have been in some measure 
related as effect and cause ; our industrial progress has partly resulted 
from the enlarged scale of the producing operations. The big 
store, the big factory, the big railroad has been able to supply its 
particular product in greater volume, at much smaller cost, and often 
of much better quality. Large scale production has meant more 
efficient production. 

Increased Specialization Possible. — Among the principal rea- 
sons for the superiority of large scale production are the following: 
Large scale production permits a great extension of the policy of 
specialization. That this policy greatly increases productive effi- 
ciency has already been brought out. The particular form of 
specialization which comes into our present topic is that which 
manifests itself within a single industrial establishment. In such 
an establishment, when the scale of production is sufficiently large, 
each man or each machine may take only some very small step in 
the total process. In a great automobile factory where thousands 
of cars are constructed every day, it is feasible to install a machine 
for stamping out a single, very small standardized part of the car, 
because the number required is so great that the machine can work 
steadily all day, and probably all night at that one unvarying task; 
whereas, in a small factory such a machine could be kept running 
only a few hours per day and so, owing to the expense of installa- 
tion and upkeep, its use would not be feasible. That large scale 
production makes possible this extreme application of the policy 
of specialization is thus one great reason why it increases pro- 
ductive efficiency. 

Economy in Factors. — A second important reason for the 
connection between large scale operations and productive efficiency 



96 PRINCIPLES OF ECONOMICS [VII 

is the fact that large scale production secures economy in the use of 
different factors or instruments. Two phases of this principle 
should be noticed. 

(i) At certain points specialization has to be carried almost 
as far in the small concern as in the large one; and the large one 
permits a fuller utilisation of the specialised factor. Thus the 
country store at Four Corners is obliged to employ at least one 
clerk, although in the long intervals between customers he spends 
three- fourths of his time whittling the nail keg; in a city depart- 
ment store, in contrast, most clerks are continuously busy waiting 
on customers. A railroad company producing transportation be- 
tween New York and Boston is obliged to lay and maintain at least 
one line of track even if, owing to the competition of other lines, 
it runs only two trains a day; but if the road conducts a large 
business, the same single line of track can at a very slight increase 
of expense be utilized by dozens of trains. 

(2) A second manifestation of the economy of large scale 
production is to be found in the fact that, while each producing 
concern has to keep in its stock of raw materials, tools, and finished 
products some reserves to meet contingencies, the reserves of a 
large concern are sure to be relatively much less extensive than those 
of the small concern. If there are four haberdasher stores in a 
town with an adult male population of one thousand, each store will 
need in the spring a stock of straw hats perhaps 50 or 100 in excess 
of its probable sales. A single large store, replacing the small ones, 
and with probable sales as great as all of them together, would need 
contingency reserves but little greater than any one of the four. 

Utilizes Waste Products. — Again, large scale production 
makes it possible to utilize waste products. A familiar illustration 
is that of the great packing houses where various portions of the 
slaughtered animals, which taken in small quantities would be 
worthless, accumulate to such an extent that the total has con- 
siderable value, and can be used with profit. Where cotton is ginned 
at a small plant, the seed extracted from the fiber is thrown away 
or destroyed ; but large ginning concerns develop from the seed 
important by-products, oil and meal. The total amount of such 



VII] PRODUCTIVE EFFICIENCY 97 

economies effected by large industries is enormous, though a small 
plant, in attempting to utilize similar waste, would spend more than 
it would save. 

Bargaining Power. — Finally, large scale production insures 
better bargains when a concern comes on the market as a buyer or 
seller. A large concern can buy its supplies more cheaply than 
a small one, because the seller, under competition, is willing to 
accept a relatively small profit in order to close the large trans- 
action; or, more important, he can often sell goods in large quanti- 
ties at a smaller rate without lowering the profit, because the 
expenses connected with the large sale — ^the selling effort, the clerical 
work, the packing, the transportation — are relatively lower than 
those connected with the small sale. In selling its product, on the 
other hand, the large concern has corresponding advantages over 
the small. Just because it produces more efficiently, it can sell at 
a lower price and yet obtain quite as high a profit. And, by means 
of its superior selling force — its salesmen, its advertising, its show 
rooms, and so on — it can usually outsell small concerns at the same 
level of prices. 

Limit to Best Size. — As a qualification upon all the comments 
made above, it should be noted that industrial units have an in- 
definite, but none the less real, limit to the size at which they can 
be effectively worked. The limit is high in some industries, like 
manufacturing, because the restricted area covered by manufactur- 
ing operations makes supervision of the workmen easy. It is low 
in other industries, such as agriculture, for the opposite reason. The 
organization unit, the unit having a single managerial, clerical, and 
buying and selling force, can, it often seems, be enlarged indefinitely ; 
but it is in fact limited by the organizing abilities of business men 
in the time and country where the unit seeks to operate— a concern 
may become so large that the securing of honest and efficient man- 
agement is well nigh impossible. The physical unit of production, 
the plant, will of course reach a size beyond which it cannot profit- 
ably be increased much earlier than will the organization, or man- 
agement, unit. 



98 PRINCIPLES OF ECONOMICS [VII 

IV 

Integration of Industries 

Meaning. — In the preceding sections we have discussed the 
conditions of productive efficiency with regard to which there is 
much confirmatory experience and Httle difference of opinion. In 
this and the following section, we meet two alleged methods of 
increasing efficiency which are of more recent origin and, in many 
minds, of doubtful value. One of these methods, which has been 
named the integration of industries, consists in bringing together 
under one control many industries which, though dissimilar, are 
interdependent. Thus the steel producer does not confine himself 
to the single process of converting pig iron into steel. He under- 
takes also to maintain a plant for making pig iron from the ore, 
and another one for getting the ore from the mine; he may in 
addition own and operate coal mines and coke furnaces to obtain 
the fuel he needs ; and may construct railways to transfer his various 
completed or partly completed products from one plant to another. 

Advantages. — One reason why this integration promotes 
efficiency is that it enables the producer to realize more fully the 
gains natural to large scale production. Another reason is that it 
secures a variety of economies, due to the complemental nature of the 
industries integrated, particularly in that each of these industries, 
save the lowest, provides a market for the product of some other 
member of the series, and thus saves the expenses of selling and 
diminishes the risk burden. The production of steel, which fur- 
nished the first great application of this method, has been and still 
is eminently successful ; and numerous other industries have in late 
years adopted a similar practice with favorable results. 

V 

Unification of Industries 

A very characteristic development of industry during the last 
twenty years, particularly in the United States, is the coalescing 



VII] PRODUCTIVE EFFICIENCY g^ 

of many hitherto independent industrial units of the same kind 
into a single all-inclusive unit. Such units are commonly known 
as trusts or combines. The practice illustrated in their organization 
is contrasted with that jlist described under Integration, in that 
the latter combines dissimilar, though interdependent, units, while 
trusts combine similar units. An integration puts together coal mining, 
iron mining, pig iron making, and steel making. A trust puts to- 
gether the American Steel Company, the Carnegie Steel Company, 
and the Illinois Steel Company. 

Evidently the formation of a trust must in most cases realize one 
of the conditions already considered, largeness of scale in produc- 
tion, and hence it must so far tend to increase productive efifi- 
ciency. Thus, a combination bank which takes the place of five 
independent banks, will be five times as large as the average of the 
five, and its efficiency will be much greater than five times the average. 

But, secondly, the combination unit will naturally have some 
advantages not necessarily belonging to an original unit of equal 
size, derived from the very fact that it is the result of combination, — 
that it has grown out of a variety of sources. For different ones 
of the combining units may have developed specially efficient methods 
or machines which, hitherto kept as trade secrets, will be much more 
fully utilized under the combination. In an equally large unit which 
was a single unit from the outset, many of these methods would 
perhaps never have been developed. 

Monopoly, Partial or Complete. — A third possible ground for 
expecting greater productive efficiency from the trust or combina- 
tion is to be found in the fact that such a combination secures 
partial or complete monopoly in the industry involved. This con- 
dition is without doubt very objectionable on a variety of grounds. 
But we are here concerned only with its relation to efficiency ; and, 
while there is room for controversy even on this side of the matter, 
the consensus of informed opinion would seem to be favorable to 
the claims of the trust.^ The chief ground on which greater effi- 



^ Perhaps the best proof of this is the tendency of all the great industrial 
nations to favor the formation of trusts (syndicates, cartels) as necessary 



lOO PRINCIPLES OF ECONOMICS [VII 

ciency is claimed for monopoly is that it makes possible a number 
of economies which are not possible under free competition. 

Legitimate Advantages. — (i) A big firm with no competi- 
tion can diminish its advertising, reduce its force of salesmen, and, 
in general, cut down all the expenses of marketing its product. 
This is equivalent to saying that the firm can produce its goods — 
from raw material to consumption stage — with less effort and at 
less cost, and therefore clearly means a gain in efficiency. (2) The 
monopoly can have plants in all parts of the country, and fill orders 
from the particular plant nearest the consumer, thus minimizing the 
costs of transportion. (3) The monopolist need not seek to adjust 
production to his possible share of a considerable demand, — a 
quantity very difficult even to approximate — he can adjust it to the 
whole demand, a quantity which can often be ascertained quite 
exactly. He thus incurs less risk from loss, and in so far as that risk 
is a cost of production he is enabled to produce more efficiently. 

It should be evident from all the above discussion that com- 
bination, whether it results in monopoly or not, belongs, on many 
important grounds, among the conditions with which this chapter 
is concerned. We are therefore probably justified in saying that, 
generally speaking, mere technical efficiency is usually increased by 
the consolidating of like industries under one control. 

Illustrative Problems 

1. Some of the big farms of East Prussia have their own little rail- 
ways, locomotives, cars, etc. What advantage of large scale production 
does that illustrate? 

2. Suppose that the five banks of Ann Arbor were to be united into 
one and that, while each of the uniting banks employs a cashier, a teller, 
a bookkeeper, and a messenger, the consolidated bank were to employ a 
cashier, a paying-teller, a receiving-teller, a discount-clerk, a collection- 
clerk, a head bookkeeper, an assistant bookkeeper, and a messenger. 
Show that the facts as stated illustrate two gains of large scale industry. 



to the maintenance of their position in the competition for the trade of the 
world. 



VII] PRODUCTIVE EFFICIENCY lOi 

3. "If the four or five dry-goods stores on Main street were united, 
a great saving in the fund of circulating capital required in that business 
would be effected." 

(a) Argue for the truth of the quotation. 

(b) Show that the new plan would probably effect a saving in fixed 
capital also. 

VI 

Industrial Freedom 

Excessive Public Regulation. — The last quarter of the eight- 
eenth century found most of the western nations dominated by 
governments which exercised a very complete despotism not only 
in respect to matters commonly regarded as well within the scope 
of political action, but also in respect to economic matters. The 
trade or occupation which each individual might enter was pre- 
scribed from his birth ; the period to be spent in apprenticeship, 
learning the trade, was likewise already arranged ; and, when he 
became a qualified workman, the amount and kind of goods he might 
produce and the remuneration he might receive for them were not de- 
termined by his will or choice, but by the law. Manufacturing 
industries also were regulated in the minutest way ; the kind of 
materials each establishment should use, the amount of materials 
it should devote to each unit of product — for example, the number 
of threads in a square yard of cloth, — and the quantity of product 
it might finish in a given time, were rigidly fixed. And, to insure 
observance of the laws, inspectors were always on hand who exacted 
penalties with the greatest severity. 

% 

Substitution of Freedom. — In its beginning this excessive 
interference with the spontaneous course of industry was probably 
justified; it had the negative effect at least of preventing labor and 
labor's output from falling below a certain standard. But there 
early developed among business men and thoughtful students a dis- 
trust of such interference. It was not only annoying, they thought, 
and inconsistent with principles of personal right and liberty, but 
it actually hindered the attainment of the result at which it was 



I02 PRINCIPLES OF ECONOMICS [VII 

aimed. Nations intended to make themselves efficient and rich, 
but by the very means employed for this end they destroyed their 
efficiency and so became poor. For various reasons, near the close 
of the eighteenth century or in the early years of the nineteenth, 
the latter notion came to be widely accepted and incorporated into 
government policy. As a result of this change, or as a result of 
it in combination with other forces, industry thereafter advanced 
at a quite unparalleled pace. Hence modern economists have come 
generally to hold the opinion that, whatever objections there may be 
to it on other grounds, industrial freedom undoubtedly contributes 
to efficiency. 

Better Guidance. — Freedom of trade we have already dis- 
cussed for this viewpoint. It widens the market for each in- 
dividual's goods, and thereby encourages that thoroughgoing spe- 
cialisation which contributes so greatly to industrial efficiency. The 
freedom of individuals to choose their own occupation and to 
produce according to self-set and market-set standards, has advan- 
tages no less important. In the first place, it tends to give industrial 
forces a direction which will naturally result in the greatest produc- 
tivity, (i) As a rule, the individual himself is better able than any 
one else to decide what he is fitted to do, or at any rate what he can 
do with keenest interest and a good will ; hence in occupations freely 
chosen, both aptitude and interest will guide him in the production of 
more and better goods. (2) By producing the things for which he is 
best fitted, a man confers the greatest number of utilities upon 
society at large, for whom the things are produced. But, conversely, 
when society comes to obtain these things by exchange from the 
producer, it also confers the greatest number of utilities upon him. 
Hence, if a man is free to choose, he will have not only the motive 
of workmanship pleasure, but also that of economic gain, for turning 
his energies into the most efficiently productive channel. 

Greater Stimulus. — Second, and no less important, is the fact 
that under a regime of freedom men are spurred on by the stimulus 
of competition or emulation. That a man has the privilege of mak- 
ing any product for which he discovers an aptitude, and of selling 



VII] PRODUCTIVE EFFICIENCY 103 

the product so widely as to gain a great profit if he can make it well 
enough, — that he may hope, on the one hand, to gain almost anything 
if he works efficiently, and that he is in danger, on the other hand, 
of losing to others almost everything if he does not so work, — these 
are conditions which call forth the most strenuous efiforts of most 
men. Finally, there are certain moral qualities generally recognized 
as requisite to good workmanship — self-reliance, decision of charac- 
ter, energy, industry, and so on — which are naturally best developed 
under conditions where the individual acts on his own initiative, not 
like an automaton under the guidance of an outside power. 

Disadvantages of Laissez Faire. — It must be admitted, of 
course, that the general truth here set forth has, like most others, 
numerous limitations. Advocates of non-interference have always 
recognized that some governmental oversight of industry is necessary 
to secure the very liberty which they wish to see prevail, since one 
individual may become so strong and so ruthless in the use of his 
strength that he will restrict the liberty of other individuals. On 
this ground, governmental action has in our day been extended very 
far — in the control of monopolistic combinations, for example — and 
that with the approval of most economic thinkers. Further, ex- 
perience under the laissez faire regime has shown that the industrial 
efficiency secured by some forms of freedom may be purchased at 
too high a price. Excessive labor of women and children, physical 
injuries from improperly guarded machinery, and kindred evils, have 
called for and secured much remedial legislation. At the present 
time, there still remain many abuses incident to great industrial 
liberty the correction of which is perhaps more important than the 
high efficiency to be derived from that liberty. It is probable therefore 
that for some time we shall see not less, but more, governmental 
interference along these lines. 

Positive Services of Government. — In addition to these purely 
restrictive forms of interference, there are others of a more positive 
nature which a government may sometimes engage in with results 
undoubtedly beneficial to industry. By its grant of franchises, a 
government encourages the building of railroads, thereby giving to 



104 PRINCIPLES OF ECONOMICS [VII 

industry all the benefits of easy transportation — especially a wide 
market — and its dredging of harbors and digging of canals contribute 
toward the same end. In a new field of activity where there seems to 
be a lack of private initiative, the government has investigated in- 
dustrial methods and offered itself, more or less informally, as an 
instructor. The agricultural experiment stations is an illustration, 
and the free bulletins and weather reports supplied to farmers. 
There has developed also in very recent years a strong movement for 
vocational direction, which aims, not to determine people's occupations 
for them by authority, but, by expert study of personal aptitudes and 
of accessible occupations, to help the individual choose the work in 
which he will be most successful. In all these lines, also, it is probable 
that the future will bring rather an increase than a diminution of 
governmental activity. 

Non-interference Favorable. — Admitting all these limitations, 
however, the statement that non-interference contributes to efficiency 
still holds good. The needed control on the one hand, and the patron- 
age or instruction on the other, should be kept at a minimum, and 
should be carried out with care and discretion. In general, industrial 
efficiency is greater under a regime of freedom, non-interference, 
laisses faire, than under one of much governmental regulation. 



CHAPTER VIII 

EFFICIENCY OF DIFFERENT FACTORS 

The preceding discussion has set forth the more general principles 
of productive efficiency. It seems desirable in addition to take up 
separately the different factors concerned in production and consider 
the conditions of efficiency peculiar to each. Let us begin, as we 
have in earlier analyses, with the labor factor. 

I 

The Efficiency of Labor 

Since the particular contribution of labor to productive processes 
is the power of force to arrange nature's materials, then labor will be 
efficient in so far as it arranges those materials relatively well. It 
remains to inquire what characteristics will enable labor best to exert 
its force, and how those characteristics may be secured. 

The Physical Side. — The first essential of the labor factor is 
mere physical strength and endurance, the ability to put forth a 
relatively large amount of force at any one moment, and to continue 
such exertion for an extended period of time. The sources of such 
strength are fairly well known. They are in part racial, evidently, 
since the workmen of one race average much higher in bulk and 
brawn and physical power than those of another race; they are in 
part matters of a narrower family inheritance, since, of two work- 
men of the same blood strain, one may exhibit capacities greatly in 
excess of the other. But with these causes we are not particularly 
concerned in the study of economics. What we are concerned with 
is the fact that of two men of equal natural endowment, one may 
supply much the greater force ; and, the reasons of this can generally 
be found in the superiority of the food he eats, of the house he occu- 

105 



I06 PRINCIPLES OF ECONOMICS [VIII 

pies, and the generally sanitary and helpful conditions under which he 
lives. From this it is but one more step to the final answer of our 
question. How do men come by the material goods necessary to 
enable them to lead the kind of life most conducive to physical fitness? 
Our present economic order being one of exchange cooperation, 
most goods are obtained through exchange from others. But, in such 
an order, the amount of goods each man gets will be affected by the 
amount of goods he himself produces and offers in trade, and, on 
the other hand, by the amount produced in the group with which he 
exchanges. Hence, the limitation of the goods that can be enjoyed 
by each man is set by the productive efficiency of the group. Men's 
real incomes, and consequently their physical strength may, then, be 
said to depend on an observance of the general laws of productive 
efficiency set forth in the last chapter — capitalistic, large-scale, laissez- 
faire production and all the rest. That this should be true, from 
a priori considerations is easy to see. But it could also be shown by 
a study of industrial history and sociology that the living conditions, 
and so the physical fitness of workmen, have uniformly been far 
superior in those countries where these laws of productive efficiency 
have been observed than in countries where they have not been 
observed. 

The Intellectual Side. — A second characteristic of the labor 
factor is mental power. Mental power is important first as the 
director and the source of skill for mere physical strength ; if one 
does nothing but pick up sticks it is better that he pick them up in an 
intelligent and clever manner. The need for skilled craftsmanship 
seems smaller in our day than it formerly was, because the man who 
once made a complete object with his own hands, tends now to be 
replaced by the man who makes only a very small part, and that by 
means of machinery. Nevertheless, the skill that was once needed 
for the direction of one's hands is now the more needed for the care 
and tending of the complicated and delicate machines. But there is 
a further use for mental strength in the labor factor. In our analysis 
of production we defined labor not as physical force only, but as 
any and all kinds of exertion, including the higher intellectual forms. 
Exertion of the mind is itself labor. In our present system of large 



VIII] EFFICIENCY OF FACTORS I07 

scale, highly capitalized production, the purely intellectual exertion 
of the promoter, the manager, and other agents is the most important 
labor of all. And so, for such labor, there is special need in the 
laborer of unusual mental power. 

Disregarding natural gifts, men acquire mental power chiefly 
through the processes of training or education. The first prerequisite 
of such acquisition is the desire of the individual ; and it often seems 
that where this desire is strongly present it will carry one over all 
obstacles to the goal. Of this point we shall speak further in a mo- 
ment. But for the masses of mankind, something else is needed, a 
something of more concern in economic studies, because it can be 
provided by economic means. Perhaps the clearest economic source 
of mental fitness will prove on examination to be identical with that 
of physical fitness — productive efficiency. For most of us it is 
necessary, first, that training facilities be provided, free and accessible, 
if not compulsory, and, second, that the immediate problem of sus- 
taining life should not press upon us too hardly, but leave us leisure 
and strength for self -improvement. But, clearly, these two requisites 
will be most fully met in a state of high productive efficiency. A 
country efficient in production will be a wealthy country ; and, other 
things being equal, a wealthy country will have more abundant means 
of education, with more opportunity for their enjoyment by its 
citizens, young and old. 

Motivation. — A third characteristic essential to the effective- 
ness of labor may be broadly named as willingness or ambition. How- 
ever great man's natural endowment of body and mind, and however 
excellent his opportunities for development, labor will always be 
ineffective if it lacks in the quality of willingness. 

The willingness to work depends primarily, no doubt, on a general 
attitude of mind which makes the possession of economic goods worth 
striving for. Occasional individuals with a taste for simplicity 
prefer to unburden themselves, as they conceive it, of all material 
things except the bare necessities of life; and, if in addition they 
are preoccupied with some idealistic pursuit, they will naturally show 
little inclination to perform economic labor. Likewise certain oriental 
peoples and religious sects regard serenity of mind and contemplation 



lo8 PRINCIPLES OF ECONOMICS [VIII 

as more to be desired than any amount of material wealth. Among 
western peoples, however, a natural taste for economic goods seems 
all but universal. So far as willingness to work depends on a desire 
for the fruits of work, they are willing enough. 

The next requisite for willingness or ambition is the availability 
of goods worth buying. A frontier settler, or a peasant in the in- 
terior of China, however keen his craving for enjoyable goods, will 
not greatly exert himself ; he will raise only what he can consume 
and will in general tend to become a shiftless no-account, unless the 
products of more civilized communities are within buying distance. 
But the only stimulus needed for these peoples is productive efficiency 
in their neighbors, and improvement in the means of transportation 
and exchange. Thus certain eastern countries have even in this gen- 
eration become keen, active producers, mainly because western na- 
tions brought to their doors commodities which they wanted, but 
which they could not have unless they produced, for exchange, some- 
thing wanted by the western nations. 

Given a natural taste for material goods, and a stimulation of that 
taste by the presence of such goods, there is still often something 
wanting to induce willingness to work. That something is an as- 
surance that, having worked, one will be allowed to consume a quan- 
tity of goods proportionate to the efifort put forth. In other words 
there must, ordinarily, be some guarantee of the reward. Now, in 
the existing economic order, the amount of a man's reward is for the 
most part determined automatically by the process known as distri- 
bution. Whether his reward, as so determined, is proportionate to 
the effort put forth, may therefore much better be reserved for a 
later part of our study. In some part, however, the assurance of 
one's reward has its source quite outside the realm of Economics 
proper. It springs from a general confidence in the moral integrity 
of the community where one lives and with which one maintains 
business relations. One must know that his neighbors are not going 
to steal his goods, whether restrained by their sense of right or by 
the policing activities of government. One must knew that the 
government itself will not confiscate his property or drain him dry 
by exorbitant taxes, and that the government is able to defend him 
from invasion and robbery by foreign foes. 



VIII] EFFICIENCY OF FACTORS 109 

II 

The Efficiency of Land 

The land factor in production furnishes man with position on the 
earth's surface, with primary raw materials, and with natural powers. 
The question of land-effectiveness in its simplest form is merely, 
"How can nature supply man with most materials of the best sort?" 
So far as nature's own part is concerned, the question is easily 
answered — she can supply most by being rich, fertile, plentiful. But 
nature is passive, what she supplies is supplied once for all, or in a 
blind and purposeless way, so her "activities," if such may be called 
her mere existence, are hardly a matter for discussion. But from 
man's viewpoint there is much to be said. How can man realize the 
greatest amount of utilities from the existing natural supply? 

Advantages of Private Ownership. — Any given individual can 
do best for himself with nature's materials if he is free to command 
all he wants at any time he wants them. Nature's materials are most 
efficient for me if I can, whenever the need arises, go out and cut 
down timber, dig ore, or plant grain on any selected piece of ground. 
But the viewpoint of particular individuals is not important here. 
Considered absolutely, land is most efficient when it is available for 
that man, among all men, who is qualified to derive from it the 
greatest product. There are several ways in which this fortunate 
availability might be secured. F'or example, a communistic form of 
government might parcel out various portions of the existing supply 
to individuals adjudged most competent. Another possible method 
is for free competition to determine who can produce most from 
each portion and then for a system of private ownership to reserve 
for that individual the exclusive use of the portion, free from the 
interference of others. The latter method is the one generally pre- 
vailing at present ; it results in a high degree of land-efficiency, and 
as such will doubtless be preserved until one unmistakably better is 
found. 

A system of free competition, private ownership and exclusive 
use can, however, be modified somewhat, and the land-efficiency 



no PRINCIPLES OF ECONOMICS [VIII 

thereby be enhanced. The condition of free availabihty for the most 
competent needs definition. Under some circumstances, land is most 
efficient if it yields all its materials at once and is thenceforth ex- 
hausted. A forest is most efficient for the pioneer and for all who 
will follow him, if he utterly destroys a large part of it to use for 
fences and firewood, and puts the denuded land under cultivation in 
small grain. But, generally, it is best that the large trees only be 
taken from a forest, while the younger ones are left to finish their 
growth, and to sow the seed of still other trees to follow them. In 
other words, nature will make the greatest contribution to productive 
processes in the long run under a policy of conservation. She will be 
most efficient through the years if she yields at no one time enough 
to diminish her future yield. But men, working under conditions of 
private ownership, cannot always be trusted to persevere in such a 
policy. Where individual wisdom and self-restraint are insufficient, 
therefore, the interference of government to advise, and even to 
enforce, conservation will contribute greatly to the- productive ef- 
ficiency of land. 



Ill 

The Efficiency of Capital 

A very little reflection will make clear that efficiency on the side 
of capital is conditioned chiefly by three things : an abundant stock, 
availability, and wise employment. The last of these depends mostly 
on the skill and capacity of the entrepreneur who determines what 
shall be produced, and so determines to what use capital shall be put. 
Accordingly, we are here concerned principally with the conditions 
which insure an abundant stock of capital, and which insure that the 
existing stock shall possess a high degree of availability. 

Abundance of Capital. — In dealing with the abundance of 
capital, the first problem which meets us concerns the origin of cap- 
ital. By what processes does it come into existence? The answer to 
this has already been in some measure anticipated, but a fuller state- 
ment is needed. 



VlII] EFFICIENCY OF FACTORS III 

Origin of Capital. — The reserve stocks of products of any 
community, its capital goods, have to be brought into existence in 
exactly the same way as consumption products, that is, through con- 
sciously directed labor assisted by land and previously accumulated 
capital. Just as certain factories are engaged in making hats, golf 
balls, candy, and other consumption goods, so certain factories are 
engaged in making engines, machines, tools, and other capital goods. 
At first sight, then, it might seem as if such a factory were the place 
to study the question: "How does capital come into existence?" In 
fact, however, we are here interested in something deeper than mere 
technical production. We are looking for the ultimate origin of 
capital, the moral origin, so to speak. This is a legitimate question to 
ask with reference to any product ; for, under an exchanging economic 
order, the technical producer of anything, whether it be an engine or 
a pound of candy, is not, in the most ultimate sense, responsible for 
its existence. He produces that engine or candy because he knows or 
expects that other people will buy it from him. He is in effect, there- 
fore, acting as the agent of those people. This is evident enough in 
production to order; but production for a general market is not 
essentially different, for it is possible only because experience has 
shown that it will work substantially the same as if production were 
to order. 

Accordingly, if we wish to know the ultimate origin of capital, 
we must go to the principal rather than to the agent. The ownership 
of engines or other capital goods means the tying up of large amounts 
of value so that for an extended period they will yield income — 
service — to the owner only at intervals and in small amounts. Not 
everyone, therefore, can afford to buy and own such goods. How 
does the actual buyer of capital goods attain his ability to buy? In 
case the buyer is an entrepreneur merely, he largely borrows money 
to make the purchase, so that a further inquiry is necessary. How 
does the man who lends money to the borrowing entrepreneur reach 
a position where he can give up, say, $3,000 in cash in exchange for 
a yearly income of $150? The answer is plain. He must have 
accumulated a money fund which promised to be for a shorter or 
longer period superfluous, which was not needed for any pressing uses 
in the present. 



112 PRINCIPLES OF ECONOMICS [VIII 

Capital Comes from Saving. — The accumulation of such a 
fund obviously requires in the first place that the persons performing 
the task shall get an income from which the accumulation may be 
made. That is, he or some factor belonging to him must produce 
wealth. But this in itself, remember, would not make him a capitalist. 
The same necessity would be present if the person in question wanted 
an equal amount of wealth to use in giving a fire-works exhibition. 
His distinctive task as a capitalist lies beyond this, — begins after the 
wealth has been provided. Out of that wealth, it is his business to 
accumulate a fund, to be kept intact for an indefinite period, though 
all the while yielding a small annual income. But this task can be 
accomplished only in one way: the prospective capitalist must save, 
must practice abstinence, must give up getting directly any gratifica- 
tion from this portion of his wealth. Looked at as a man who has 
by his sacrifices put himself into possession of, say, ten thousand 
dollars, he is merely a producer of wealth. On the other hand, 
looked at as a man who has given up the privilege of using for the 
satisfying of his wants, say, five thousand dollars out of this total, 
he is a producer of capital. 

At this point, however, a word of caution is needed. The state- 
ment that capital can be accumulated only by saving should not be 
interpreted as meaning that, in producing capital, one necessarily 
experiences some deprivation. To a very large extent, the capital 
of the community is accumulated by persons of whom this could not 
be said : — ^to them saving is often easier than would be consuming the 
immediate products on which their savings might be expended. But 
this in no degree changes the real nature of the process. The fact 
remains that the person who produces capital, instead of using the 
five thousand dollars of our illustration for gratifications, devotes 
them to the building of a fund permanently in reserve, a mere 
income-bearer. 

Another point should be noted here — ^that the person who by his 
saving is building up capital may or may not retain his savings for 
long as a distinct money fund. He cannot "spend" them, in the 
popular sense of the word, that is, pay them out for consumption 
goods such as food, clothing, excursions, and the like, which go 
directly and exclusively to the satisfying of present wants. But he 



VIII] EFFICIENCY OF FACTORS II3 

can part with the money in exchange for engines, houses, or other 
income-bearing property; since, in doing that, he merely invests the 
money, and has in reahty as large a sum of wealth as ever. This is 
a distinction familiar to the business world ; but it is frequently over- 
looked and so becomes the source of a popular fallacy about money. ^ 
Bearing these distinctions in mind, the act or process of saving 
can have no deeper analysis. It is just saving, going without 
some gratification in the present which one might enjoy if he 
chose. The capitalist receives a money income ; he spends part of it 
consumptively, but refrains from spending the rest — holding it as 
money or investing it; in consequence, he accumulates a fund with 
which he himself, or some one else to whom he lends it, can buy 
engines or other productive goods. As economic society is at 
present constituted, this is substantially the only process in which 
capital grows : get an income; save from that income. But, since 
the existence of an income is implied in the saving from it, we may 
cover the whole problem in a single statement : Under the existing 
economic order capital originates chiefly in saving or abstinence. 

Illustrative Problems 

I. Suppose that a community of say 50,000 persons living on an 
island, completely isolated from all other communities, but otherwise liv- 
ing under an economic system like ours, with division of labor, trade, 
metallic money, etc., should attempt to increase its capital by issuing 
$100,000 of paper money. 



" Before leaving this point, a word of caution ought to be added. In 
insisting that capital has its origin in saving, we must not forget what has 
been brought out in another connection, that the supplying of capital involves, 
not merely the accumulating of a fund of money or credit, but also the 
actual, mechanical producing of the concrete or goods capital — the engines, 
cars, machines, etc. We cannot furnish power or carry ore or make nails 
with stores of money, — we must have real engines and cars and machines. 
Nevertheless, this way of looking at the matter, which fits the needs of 
technical production, gives us no light on the origin of capital. The technical 
making of any particular piece of capital does not originate that capital. 
As remarked above, the man who is really responsible for the existence of 
the capital is the one who accumulates the fund of money; and the conditions 
which he has to fulfil in accomplishing this disclose the fundamental nature 
of the process whereby capital comes into existence. 



114 PRINCIPLES OF ECONOMICS [VIII 

(a) Argue for the contention that, in general, we should expect this 
attempt to fail. 

(b) Try to find some reasons for thinking that the scheme might 
realize a small measure of success. (Would said scheme tend to increase 
the total output of labor services? Would it tend to release any labor 
hitherto devoted to the old tasks?) 

(c) Change the hypothesis by supposing the given community to be 
in free trade relations with many other communities, and argue that the 
proposed issue would really increase the capital of the community. 

2. "When the primitive fisherman refrains from eating fish in order 
to accumulate a store to be eaten while he makes a net, we obviously have 
a case of real saving. But when a capitalist keeps his money rather than 
spending it, things are very different. The good things our capitalist 
refrains from consuming have not been made at all; instead, producers, 
knowing that capital is being accumulated, are making engines, cars, etc., 
which obviously could not be consumed. But, if they could not be con- 
sumed, they could not be saved. Such capital, therefore, does not result 
from saving." 

Taking as your definition of saving this : "Saving is going without 
something one might otherwise enjoy," show that the capitalist who 
accumulates a fund of money does really save. 

3. Suppose that, instead of proceeding as at present, the capitalist 
were himself to make the concrete pieces of capital, hoes, plows, planes, 
engines, etc., and then lend these to producers for hire. Would such 
making of capital involve saving? 

4. Suppose that a communistic state, in order to increase its stock of 
capital, should proceed to require from every citizen one more hour of 
labor daily. Would this way of building capital involve saving? 

We have seen that capital comes into existence chiefly through 
saving, abstinence — a deliberate relinquishment of the present disposal 
of income. What conditions favor the practice of this line of 
conduct ? 

Large Incomes Favor Capital Accumulation. — One condition 
certainly would seem to be the existence of large incomes. It is very' 
hard for people of small incomes to save anything, and hard for those 
with moderate incomes to save much; all they can get together is 



VIII] EFFICIENCY OF FACTORS I15 

urgently required for their immediate wants. People with large 
incomes, on the contrary, are able to save with ease, simply because 
there remains a considerable surplus after their immediate, pressing 
wants have been satisfied. But what conditions are favorable to the 
existence of large incomes? Doubtless the most essential condition 
is the one we are discussing, namely, high productive efficiency. The 
man who produces by ineffective methods will naturally have but a 
small product, and hence will need to consume most of it for each 
day's sustenance. The primitive fisherman, equipped only with his 
pair of hands, commanded a very small income of fish; and so it was 
only with the greatest difficulty that, while feeding himself today, he 
could save anything for tomorrow. But, once possessed of a canoe 
and a net, the capitalistic method of fishing enabled him to catch in 
a day far more than the day required, and hence to save from it much 
and easily. 

Assured Gains. — A second condition, or set of conditions, 
favorable to saving is one which insures to capital the expected ad- 
vantage of saving. As in the case of labor, the first assurance of an 
appropriate reward must spring from the existing system of distribu- 
tion. But there are other sources. A man will have more inclination 
to save under a strong and beneficent government, where he feels 
confident his accumulations will not be taken from him by theft, 
invasion, or extortion. He will save most, too, in a flourishing 
country, where the industries have become highly capitalistic, so 
that every smallest addition to his surplus can readily find a use, 
and that at a rate of interest fairly high. 

Good Banking Institutions. — A third condition inciting men 
to abstinence is the existence of social machinery suitable to aid in 
caring for, and investing, their accumulations. A public banking 
institution with burglar and fire-proof vaults conduces to saving, 
because one can intrust his accumulations to this, and be relieved of 
all anxiety as to their safety. Banks, also, offer strong inducements 
of another kind, in that they find for the capitalist an opportunity to 
invest. An ordinary producer knows well enough how to practice 
abstinence — he can save his hundred dollars, or his dollar, or his dime 



Il6 PRINCIPLES OF ECONOMICS [VIII 

a day ; but in a complex industrial society like ours he is usually 
helpless about turning it to use. He sees no business near at hand 
requiring his savings, and he cannot set out to seek one that does. 
Even if he found one, he would have no capacity for judging of its 
soundness. Furthermore, his savings may be very small, and such 
sums as he could offer would be so inadequate that no business man 
would bother to accept them. A bank, on the contrary, is a careful 
student of business enterprises, and an expert judge of their sound- 
ness, so it can take off the saver's hands all the trouble of finding an 
investment. And, finally, since it can merge his small savings with 
many other small ones,^ it can quite readily put them to use, and so 
still further encourage him to save. 

A fairly adequate general answer to our question can be put in a 
single sentence : The accumulation of capital is favored by the ex- 
istence of large incomes, by conditions which insure to capital the 
expected advantages of saving, and by the presence of suitable social 
machinery to aid in caring for and investing accumulations. 

Illustrative Problems 

1. Give reasons for expecting capital to accumulate more rapidly 
in England than in Scotland, in Germany than in Persia. 

2. Suppose the total income of industry in the United States were 
divided equally among all the citizens, do you think capital would grow 
as rapidly as it now does? Why? 

3. Explain why postal savings banks would be expected to increase 
the accumulation of capital ; same for loan and trust companies ; same for 
insurance companies. 

4. From our present standpoint, argue for or against the system of 
guaranteeing bank deposits. 

High Availability of Capital. — We have examined the first 
requisite of efficiency on the part of capital — an abundant supply. 
A final question remains: How, after capital has been abundantly 



' A bank, of course, utilizes not only the funds which people have 
definitely set apart to play the role of capital, but also a great amount of 
wealth which is only momentarily idle. 



VIII] EFFICIENCY OF FACTORS 1 17 

saved, can it be made available for those who need and are competent 
to use it ? 

When a man himself uses the capital which he saves, this question 
has no pertinence. But, in modern industry, capital is generally 
saved by one set of men and used by another. Availability therefore 
turns upon how the two parties can get together, how lending can be 
made easy on the one side and borrowing on the other. The first 
part of this question has already been answered : lending is made 
easy by the existence of institutions which specialize in that type of 
work. But borrowing is made easy in precisely the same way. 
Where good banking institutions exist the business man desiring 
capital knows at any moment where a fund lies waiting for invest- 
ment ; and so he can present his demand at this single place, instead 
of hunting out the individual capitalist — or perhaps many small cap- 
italists. He is also spared the trouble of proving his soundness to 
each small holder — many of whom are anyway unable to judge — 
and furnishing security to satisfy them. He can prove his soundness 
once for all before men well qualified to judge, and obtain the whole 
sum desired without further difficulty. 

As under the preceding head, the general conditions for rendering 
capital available can be put in a single sentence : The availability of 
modern capital depends on a high state of entrepreneur credit and 
high efficiency in the institutions which deal in money capital — 
hanks, trust companies, and so on. 

Illustrative Problems 

1. For some years before and after 1892, it looked to European ob- 
servers as if the United States were likely to give up the gold standard 
and adopt silver, thus reducing the value of the dollar, as most expected, 
by about forty per cent. What effect would you expect this condition to 
have on foreign capital in the United States? 

2. The existence of the ordinary commercial bank enables us to 
make available quantities of money capital out of funds which are not 
really set aside for use as capital, but rather are being kept for daily use. 
Try to explain how that can be. (Suppose that 500 persons kept the 
funds which they expect to put to everyday use in a bank, and made 
payments partly by cash drawn out, partly by checks drawn in favor of 



Il8 PRINCIPLES OF ECONOMICS [VIII 

one another. Show that the bank could safely treat a considerable part 
of the funds as if they were going to be permanently idle.) 

3. In Germany there are many agricultural loan associations which 
issue jointly guaranteed bonds to the lending public, then lend to their 
members on ordinary mortgage security. Does it seem likely that this 
system would tend to make capital more available to farmers ? 

IV 
Efficiency in Respect to the Entrepreneur Function 

As has already been made clear, the central function in all pro- 
duction is that of the entrepreneur, the person, natural or legal, who 
undertakes any particular business, — assumes the responsibility of 
bringing it into existence, or, anyhow, of continuing it. This of 
necessity requires that he shall carry the major part of the risk in- 
volved and that he shall himself perform certain fundamental mana- 
gerial duties. What conditions, now, are necessary to enable entre- 
preneurs to serve efficiently in these functions? 

There are three chief requisites of efficient enterprising, (i) an 
adequate supply of land, labor, and capital, (2) judgment and fore- 
sight in recognizing opportunities for business undertakings, and 
(3) a spirit of enterprise, or initiative, — readiness to assume the re- 
sponsibilities of production when an opportunity is recognized. The 
first item calls for little comment. Since the entrepreneur achieves 
all his results in production by using the other factors, his efficiency 
will naturally depend on having them to use ; but all questions relating 
to the supply of other factors are well enough treated in the pages 
immediately foregoing. The second and third requisites are perhaps 
also self-explanatory ; but the conditions which foster them in a com- 
munity are, owing to the central position and the signal importance 
of the entrepreneur function, worth a moment's examination. 

Education. — The qualities of judgment and foresight in recog- 
nizing good opportunities are in great measure matters of natural 
endowment. They exist apparently in some men and some races, 
and in other men and races they are absent. On the other hand, they 
are to some extent capable of being taught ; and, to that extent, those 



VIIIJ EFFICIENCY OF FACTORS 1 19 

countries will have the greatest fund of entrepreneur power which 
employ the best methods of teaching it. A community successful in 
business and largely given up to business activities and ideals will 
unconsciously educate itself. By example, on the one side, and 
imitation, on the other, it will inevitably disseminate knowledge to all 
classes of people, and pass down a gradually accumulating store from 
generation to generation. But further, business can be, and, as 
thinkers are beginning to realize, should be, made a subject of formal 
study. Recent years have brought an enormous development in this 
line : the conditions underlying and surrounding business successes 
are analyzed, statistics are compiled and weighed, and the general 
principles of economics are used in the solution of practical business 
problems. Facilities have also been created for supplying this scien- 
tific information methodically to anyone who wishes to obtain it. 
The output of business books has been a striking phenomenon of the 
last decade, while colleges have grown up which teach not only the 
broader economic principles upon which business is based, but also 
the very details of business method. It is not unreasonable to expect 
that by these means the ability of men in general to recognize and 
estimate good opportunities will be markedly increased — in other 
words, that the entrepreneur function in production will be made 
more efficient. 

Initiative. — The third quality essential in entrepreneurs was 
described as enterprise, initiative, or readiness to assume the responsi- 
bilities of production. If a country fails to develop men of the 
peculiarly adventurous type who are willing to assume the responsi- 
bilities of production, the entrepreneur function in that country will 
be very poorly performed. In consequence, since the cooperation of 
all other factors depends on the entrepreneur, the country may have 
abundant natural resources, labor power, and capital, but until men 
appear — perhaps coming in from other countries — who dare to at- 
tempt great combinations of these factors, industry will remain at a 
standstill. 

Limited Liability. — The enterprising spirit, like good judg- 
ment, may in part be attributed to natural endowment — western races 



I20 PRINCIPLES OF ECONOMICS [VIII 

are, or, until the recent rise of the Japanese, were assumed to be, 
more enterprising than eastern. But probably in greater part this 
quality depends upon external fostering conditions. Thus, something 
less than a century back, the unlimited-liability partnership form of 
cooperative undertaking was much the most common. Under this 
form, a man starting a new enterprise which might, for all he knew, 
result in failure, stood to lose all he owned. At the present time, the 
form of organization more commonly used is one possessing the 
characteristic of limited liability : the members are responsible for the 
debts of the organization, not to the full amount of their property, 
but only to a strictly defined sum — ^the sum they have put into the 
business, or perhaps that and as much more. Naturally, under the 
latter conditions, more than under the former, men will be ready 
to venture upon new and dangerous enterprises. 

Again, where the risk of undertaking enterprises is great, men 
must have some assurance that in case of success their gains will be 
correspondingly great. The patent laws must be effective, so that 
when a man launches on the market an untried article he will not be 
robbed of his unusual gains by others who manufacture the same 
article as soon as the dangers have been overcome. A man must 
know also that his property will not be destroyed or stolen by people 
whom the government cannot control, and that his profits will not 
be taken from him through merciless taxation imposed by the gov- 
ernment itself. Finally, the spirit of enterprise is certain to assert 
itself more freely \^here some kind of machinery, legal and indus- 
trial, exists to help it. Thus, in earlier times, corporations came into 
existence only by a special act of the legislature; in our day they 
are formed much more readily by administrative process under the 
authority of a general law. Every large city has also nowadays a 
stock exchange where the shares of corporations are daily bought and 
sold, thus reducing the task of acquiring control of an enterprise to a 
simple market transaction. 

The conclusions of all this part of our discussion may now be 
summarized as follows : High productive efficiency in respect to the 
entrepreneur function, in so far as it is not a matter of natural en- 
dowment merely, depends chiefly on the maintenance of conditions 
which (i) minimize the individual risk-burden of undertaking, (2) 



VIII] EFFICIENCY OF FACTORS I2I 

make possible the quick and easy entry into, and withdrawal from, 
enterprises, and (3) provide or permit large profits where risk is 
unavoidably great. 

Illustrative Problems 

1. Give two or three ways in which patent right laws contribute to 
productive efficiency. 

2. There is much to be said in condemnation of our recklessness in 
permitting private individuals to exhaust our vast stores of natural wealth 
in gold, silver, oil, copper, etc. What can be said on the other side ? 

3. Was there any excuse for the great liberality displayed in the 
granting of trolley car franchises in the late eighties ? 

4. Argue for the contention that a much more efficient protection of 
the public against dishorest promoters of mining and other enterprises 
would contribute greatly to productive efficiency. 



CHAPTER IX 

INCREASE IN OUTPUT AND RATE OF PRODUCTION 

Looking at the situation broadly, man finds himself set over 
against a natural world, from which through his own efforts and 
sacrifices he can and must make himself a living, — can and must 
produce the goods necessary to life and happiness. This natural 
world over against which he is set, and from which he must wrest 
a living, is practically a fixity : even from the standpoint of many 
generations, it experiences no increase in volume or capacity ; indeed, 
as respects important raw materials, it even shows a diminution. 
On the other hand, population in most countries, certainly in the 
world as a whole, constantly increases. It follows that, from a 
natural plant which is practically unchanging, an ever-increasing 
output of economic goods must be produced. In this situation, it 
becomes of much importance that we should study the results which 
follow our efforts to increase output, and ascertain, as far as we may, 
to what extent these efforts are likely to be successful. 

Certain aspects of this problem have already been touched upon, 
at least by implication, in discussing productive efficiency. In view 
of the fact that different policies in the conduct of production result 
differently in respect to the volume and goodness of product, it, of 
course, follows that we can increase total output for any given period 
over that of some earlier period, provided that in the earlier period 
we have pursued a less efficient policy and are now in a position to 
resort to the more efficient one. Further, as discovery and invention 
supply us with new and more eificient methods and policies, we can 
increase total product by resorting to these. 

The Problem. — But considerations such as the above, though 
of great importance, are too evident to need any prolonged discussion. 
There is a much more difficult body of doctrines having their root in 
the fact that changes in the proportions in which the factors of pro- 

122 



IX] OUTPUT AND RATE OF PRODUCTION 123 

duction are combined are quite sure to cause changes in the quantity 
of product obtained per unit of any one of the factors. Setting two 
men to work~ a piece of land hitherto worked by only one would 
probably mean a larger total product ; three workers might make the 
product still larger ; and so on ; though the time would doubtless 
come when additions to the amount of labor expended ceased to in- 
crease product, perhaps even reduced it. Moreover, even while out- 
put was being increased, the changes would probably not be uniform. 
The increases might be more than proportional to the increases in the 
labor, or just proportional, or less than proportional. Here, evident- 
ly, we have a very fundamental problem — a problem which, though 
seeming elementary, contains a veritable nest of complications. 

In the above introduction to our study of the effect of changes in 
combining proportions, we set out with the fact that some vital 
factors in production are limited in amount and so we need specially 
to know something about the limits of their productive capacity. In 
other words, one problem involved in this connection is to determine 
the obstacles which meet us when we try to get more out of a fixed 
amount of some factor or group of factors. The study of this prob- 
lem, however, at once brings us to a complemental problem : What 
is the result of trying to utilize a larger amount of those factors which 
can and do change in amount? If, in using the land of a country, 
we have come to a point where more labor spent on the land will 
increase the product of that land but only at a less than proportional 
rate, it follows that we have also reached a point where we cannot 
make as good use of additional units of labor, as we have made of the 
previous ones. These may be thought of as the principal problems 
involved in our present study. 



General Solution of Problem for Individual Productive 
Instruments 

As already indicated, our problem is of most significance when 
we are thinking of a whole people over against its total outfit of 
natural resources; but, manifestly, we could not expect to obtain 
light on this larger question unless we had made some study of 



124 PRINCIPLES OF ECONOMICS [IX 

the behavior of individual units of our productive factors. In order 
to learn how the total outfit of a nation will react when we try to 
increase its total production by spending more effort upon it, we 
must first ascertain how a particular piece of land or a particular 
machine or a particular power plant behaves under similar treatment. 
Accordingly, this chapter is devoted to answering the question: 
What results follow zvhen we try to increase the output from any 
instrument of industry by increasing the quantity of the auxiliary 
factor or factors combined with it? 

Principle of the Three Stages. — In making a general answ^er 
to this question, let us suppose ourselves to experiment with a com- 
mon hot-air furnace of the size adapted for heating a 12-room house, 
and to ask what results we should get from using for each experi- 
ment a larger charge of coal than for the preceding one, the total 
quantity to be applied in a period of two hours. If, for example, 
we were to make our first experiment using 10 pounds of coal, in the 
next one 20, in the next 30, and so on, we may be pretty sure that 
the results would be something like the following: The first experi- 
ment would probably deliver no appreciable amount of hot air, — ^the 
heat produced being all absorbed by the furnace itself and the con- 
ducting pipes. The second experiment with 20 pounds of coal might 
supply enough heat to raise the temperature of a room of 200 cubic 
feet to 70 degrees. The 30-pound experiment might raise to the 
same temperature twice as much space, though the amount of coal 
used was only one-half greater. The 40-pound experiment might 
heat 1,000 cubic feet, two and one-half times as much as the 30- 
pound test, though the increase in coal was only one-third. This 
more than proportional increase in the work done might continue 
for several more experiments. But presently a test would come 
which, though showing some increase in the total work accomplished, 
showed an increase less than proportional to the increase in the 
charge of coal. Thus the 80-pound test might give us heat for 8,000 
feet, while the 90-pound gave us only enough for 8,800 feet : — the 
coal used increasing one-eighth, but the work done increasing only 
one-tenth. Finally, after this less than proportional increase in work 
had gone on for some time, a point would be reached when a larger 



IX] OUTPUT AND RATE OF PRODUCTION 125 

amount of coal would smother the fire and actually diminish the 
amount of heat delivered. To summarize, as soon as our combina- 
tions began to give results at all they would fall into three groups : 
(i) Output increasing more than proportionally to the increase in 
the auxiliary factor (coal) ; (2) output increasing less than propor- 
tionally; and (3) output diminishing. For convenience in reference, 
let us call this tendency of the combinations the Principle of the 
Three Stages. 

Of General Application. — In the above paragraph, the heat- 
ing furnace supplied an illustration easily understood and one in 
which the truth of the conclusion laid down is so evident as to make 
proof unnecessary. But it will scarcely be doubted that the same 
principle applies quite generally in economic production. If, for 
example, we were to take a ten-acre field devoted to raising potatoes, 
and, in successive seasons, use in cultivating that field first i day's 
labor, then 5 days', then 10, then 15, and so on, we should doubtless 
get results analogous to those found in coaling the furnace. For 
several experiments the crop would increase more than proportion- 
ally to the increase in the labor, then less than proportionally, and 
finally would diminish. 

As to the existence of the first and third stages indicated, there 
surely is no room for doubt : the amount of labor used might be so 
small that increasing it would more than proportionally increase the 
crop, and the amount of labor might already be so great that in- 
creasing it would actually cut down the crop. As respects the second 
stage, some doubts have been expressed, but they seem to have little 
ground. The universal practice of farmers in a matter so fundamental 
as this must surely be based on a trustworthy induction; and that 
practice fully confirms our contentions that the second stage exists. 
First, farmers do not try to raise all the produce wanted on a single 
piece of ground. Instead, they use many pieces. But this they 
would not do, if the amount raised from one piece could be increased 
indefinitely at the same rate as the labor applied to it. Secondly, 
after having extended cultivation to inferior lands, they return to 
spend more labor on the superior ones, when the price rises high 
enough to warrant spending the additional labor for a smaller pro- 



126 PRINCIPLES OF ECONOMICS [IX 

portional return. And this they would not do, unless the policy 
added something to the crop. There is a stage, then, in which output 
is increasable but not increasable in proportion to the increase in the 
auxiliary factor. 

II 

Illustration from an Imaginary Experiment 

The above account of the general principle underlying the be- 
havior of individual industrial factors when we try to increase output 
by increasing the quantity of assisting factors, is so obviously true 
for such cases as those considered, so much a matter of everyday 
experience, that we should almost seem justified in omitting its fur- 
ther discussion. In fact, however, the topic is extraordinarily pro- 
lific in misunderstandings; so much so that it seems necessary to 
spend considerable effort in trying to insure a clear, accurate com- 
prehension of the doctrine itself and the various corollaries and con- 
sequences derivable from it. To this end, we shall ask the student 
to follow the assumed results of an imaginary series of experiments, 
embodying the working of things in very definite and detailed arith- 
metic form. 

In this series of imaginary experiments we use each time 20 
units of one of the factors, which we will call N, and combine with 
these increasing quantities of another kind of factor, which we will 
call L, using first 2 units of these L's, then 3 units, the next time 4 
units, and so on. These figures are given in the second and third 
columns of our table, — the first column being used merely to show 
the number of the combination. The quantity of output which re- 
sults from each of our imaginary combinations is of course assumed 
arbitrarily, and appears in the fourth column. Thus the fifth combi- 
nation, using 20 N's with 6 L's, is supposed to give 84 units of prod- 
uct, and the ninth combination, using 20 N's with 10 L's, to give 200 
units of product. 

As just indicated, the figures of the second, third, and fourth 
columns contain the assumed conditions and the assumed general 
results of our series of imaginary experiments. In contrast, the 
figures of the remaining columns are derived from the data assumed 
in the preceding ones. First, come the parenthetical figures of the 



IX] 



OUTPUT AND RATE OF PRODUCTION 



127 




d 


1 

H 

u 


tion 
Amount 

of N's 


-M 


a, 



Propor- 
tional 
Increase 


< d 


> •- 

< 


u 
a; 
> 

< 


m 

^ 


Marginal 

Product 

of L's 


I 




II 


III 


IV 


V 




VI 


VII 




VIII 


I 




20 


2 


2 






.1 




I 






2 




20 


3 


6 


(0 


4 


•3 




2 




4 


3 




20 


4 


16 


(2) 


10 


.8 




4 




10 


4 




20 


5 


35 


(4) 


19 


1-7 




7 




19 


5 




20 


6 


84 


(7) 


49 


4.2 




14 




49 


6 




20 


7 


126 


(14) 


42 


6.3 




18 




42 


7 




20 


8 


156 


(18) 


30 


7.8 




19-5 




30 


8 




20 


9 


179 


(19.5) 


23 


8.9 




19.8 




23 


9. 




20 


10 


200 


(19.8) 


21 


10 




20 




21 


10 




20 


12 


236 


(40) 


36 


11.8 




19.7 




18 


11 




20 


14 


266 


(39) 


30 


13.3 




19 




15 


12 




20 


16 


290 


(38) 


24 


14.5 




18.1 




12 


13 




20 


18 


312 


(36) 


22 


15.6 




17.3 




11 


14 




20 


20 


330 


(34) 


18 


16.5 




16.5 




9 


15 




20 


22.2 


346 


(36) 


16 


17.3 




15.6 




7.2 


16 




20 


25 


362 


(43) 


16 


18.1 




14.5 




5.7 


17 




20 


28.5 


380 


(50) 


18 


19 




13.3 




5 


18 




20 


33-3 


393 


(63) 


13 


19.6 




11.8 




2.6 


19 




20 


40 


400 


(78) 


7 


20 




10 




1.1 


20 




20 


44-4 


398 


(44) 




19.9 




8.9 




02 

4) 


21 




20 


50 


393 


(50) 


05 


19.6 




7.8 






22 




20 


57-1 


360 


(56) 


en 

a 


18 




6.3 






23 




20 


66.6 


280 


(60) 




14 




4.2 




a 


24 




20 


80 


140 


(56) 




7 




1-7 






25 




20 


100 


80 


(35) 


< 


4 




.8 




i 


26 




20 


133-3 


40 


(26) 


2 




•3 




27 




20 


200 


20 


(20) 




I 




.1 




< 



fifth column. These are intended to show what the increase in out- 
put would have been if it had been just proportional to the increase in 
the number of L's. But a proportional increase means one which 



128 PRINCIPLES OF ECONOMICS [IX 

just maintains the average of the last preceding combination. Thus, 
the average for the fourth combination is 7 units for each L, and 
hence, if the L of the fifth combination is to maintain the average, it 
must bring in seven units. Accordingly, the figure in this column 
for the fifth combination is 7. 

The figures in this fifth column which are not in parenthesis 
represent the actual increase in output, and are, of course, obtained 
for any particular combination by subtracting from the total of that 
combination the total of the combination next preceding. Thus from 
the 312 output of the thirteenth combination, we subtract the 290 of 
the twelfth and get 22, the actual increase for the former combina- 
tion, and this figure, therefore, appears in the fifth column outside 
the parenthesis. 

The figures in the sixth column give the average total output for 
the corresponding combination measured in N's. Thus the figure 
14.5 in this column for combination 12 means that the average output 
for each of the 20 N's in this combination is 14.5. That figure 
is of course obtained by dividing 290, the total output for this combi- 
nation, by 20, the number of N's used. The figures of the seventh 
column similarly show the average total output measured in L's. Thus 
the 1 8. 1 appearing in this column under this same combination means 
that the average output for each L is 18.1, a figure obtained by divid- 
ing the total output, 290, by 16, the number of L's in this combina- 
tion. 

Finally, we have in the eighth column, the addition to output which 
follows upon * the addition of one units of L's. Thus the 12 appear- 
ing in this column under the twelfth combination means that for each 
new L appearing in this combination, 12 more units of product appear 
in the output. This figure is of course obtained by dividing 24, the 
total amount added, by 2, the number of L's added. In the first 8 
combinations the figures for this column are the same as those which 
appear in column 5 outside parentheses, because in each case there 
is but one L added, and so division by the number of L's does not 
alter the figure of the addition. 



* This must not be understood to mean that this addition is produced 
solely by the unit of L's in question. 



IX] OUTPUT AND RATE OF PRODUCTION 129 

A brief inspection of our table will show that it represents 
symbolically the phenomena which were set forth above as present in 
real life. No actual combinations of factors behave in precisely the 
way indicated in this table ; but the general course of things is strictly 
regarded. We have but to follow the figures given in the fifth 
column to see that, for the first 9 combinations, output increases more 
than proportionally; that, for the next 10 combinations, it increases 
less than proportionally; and that, for the last 8 combinations, it 
absolutely diminishes. In short, it passes through the 3 stages 
through which real combinations pass. Accordingly, we can safely 
use the figures of this table to bring out in definite and precise form 
the points directly or indirectly involved in our principle. 

Illustrative Problems 

1. Assume that the total output for the twelfth combination is 294 
units instead of 290, and compute the figures which would result from 
this new assumption in the part of the fifth column not in parenthesis, 
and in the sixth, seventh, and eighth columns. 

2. If you had at your disposal 10 N's and 8 L's, what combination 
would you naturally use? What one, if you had 40 N's and 32 L's? 
If you had 5 N's and 4 L's? 60 N's and 75 L's? 

3. If you had at your disposal 60 N's and 48 L's, how much product 
would you naturally be getting? How much would you naturally get, 
if you were to put in 6 more L's? How much, if you added another 
6 L's? 

Ill 

Changes Caused in Averages as Measured in Each of the Two 

Factors 

Average Measured in L's. — The next point to be remarked 
concerns the changes caused in the average output as measured in one 
or the other of the factors. This is, indeed, only another way of 
looking at the facts already presented, but it is a way of much interest 
and importance. How, then, does the average measured in L's be- 
have ? The seventh column of our table shows that it increases up to 
the ninth combination, then diminishes to the end. Moreover, the 
table shows a perfectly definite reason why this must be so. The 
average output for any combination, measured in L's, is, of course, 



I30 



PRINCIPLES OF ECONOMICS 



[IX 



equal to the total output for that combination divided by the number 
of L's used in the combination. But, if for any series of combina- 
tions the total output is increasing more rapidly than the number of 
L's, (as it is for the first 9 combinations), the quotient obtained, 
that is, the average, must be increasing. On the other hand, if for 
any series of combinations the total output is increasing less rapidly 
(as it is for the 10 combinations after the ninth) than the number of 
L's, the quotient, and so the average, must be diminishing. Finally, 
if output is diminishing absolutely while the number of L's is still 
increasing, the average must of course be diminishing. The average, 




Averages in L's and N's 



measured in L's, therefore, first increases up to the ninth combina- 
tion, then diminishes to the end. 

Average Measured in N's. — The behavior of the average 
measured in N's, as represented in the sixth column, is necessarily 
somewhat different. Since the total output is increasing up to, and 
including, the nineteenth combination, while all the time the number 
of N's used remains constant, — ^that is, since the dividend increases 
while the divisor remains constant — the average, measured in N's, 
must increase throughout this series. On the other hand, since the 
total diminishes after the nineteenth combination while the number 
of N's remains constant, the average, measured in N's, must diminish 
after the nineteenth to the end. 



Summary. — Summarizing the points made above and the 
most immediate inferences therefrom, we have the following : First, 



IX] OUTPUT AND RATE OF PRODUCTION 131 

each average rises during a series of combinations ; reaches a maxi- 
mum in one particular combination ; then diminishes for the re- 
mainder. Secondly, the maximum average combination is differ- 
ent for the two averages, being an early one for the L-average, a 
late one for the N-average, — a proposition which plainly follows 
from the conditions. In the third place, the average measured in 
either factor is bound to be an increasing one for every combina- 
tion prior to the tenth ; that average measured in either factor will 
be a diminishing one for every combination after the nineteenth ; 
and, for the intervening combinations, the average will be a dimin- 
ishing one, measured in L's, but an increasing one, measured in N's. 
These points are brought out graphically in the accompanying dia- 
gram, in which the continuous curve represents the averages measured 
in L's, while the dotted curve represents the averages measured 
in N's. 

IV 

Changes in Additions or Marginal Products 

Another effect of attempting to increase output by increasing one 
of the factors concerns the changes caused in the addition to output 
as measured in the addition to the changing factor. Thus the thir- 
teenth combination shows an increase over the preceding one of 
22 units of output, while the number of L's added to make this 
combination was 2; and, dividing 22 by 2, we have ii, which is the 
number of units of product added for each of the L's added. 
With some show of reason, this quantity is frequently designated the 
marginal product ^ of the L's — that is, of the increasing factor. 
Anyhow, the course which it takes as we increase the quantity of 
L's used is of considerable importance. That course is indicated in 
the last column of our table. It begins at 4 in the second com- 
bination ; increases to 49 in the fifth ; from thence grows smaller 
and smaller to the nineteenth ; after which it remains less than o. 

These results are inevitable so long as the relation between 
the increase in output and the increase in the number of L's is the 
exact relation assumed in our table. The addition to output for each 



See Note 2, Appendix. 



132 PRINCIPLES OF ECONOMICS [IX 

added L is just what it is because the relation between the increase 
in the total output and the increase in the total number of L's is 
just what it is. We must not infer, however, that the precise course 
taken by the marginal additions in our table is the only one which 
they could take under the general conditions assumed, namely, the 
conditions that output increased more than proportionally up to the 
ninth combination inclusive, then less than proportionally to the nine- 
teenth, and then diminished. The precise course taken by the 
marginal addition or product as a result of a change in the propor- 
tion between output and the number of L's, depends, not only on 
the direction of that change, but also on its degree. Thus, if the 
proportional increase in output had been less rapid during the 
earlier combinations or had fallen off less sharply in the later ones, 
the change from an increasing to a diminishing marginal product 
would have come later. Other possible variations in the behavior 
of the marginal product from that indicated in our table could 
easily be worked out arithmetically. Nevertheless, if we assum.e 
that the course taken by the output in our imaginary experiment 
was fairly typical, — and I think we may properly do so, — ^the course 
taken by the marginal product would correspond in a general way 
to that which it takes in our table: that is, marginal product would 
increase up to a maximum coming somewhat earlier than the com- 
bination at which the increase in output became less than propor- 
tional, then diminish to the end. 

Before leaving this topic, we must emphasize one aspect of the 
matter just commented upon, — the fact that the point where marginal 
product begins to diminish does not correspond with the point where 
the increase in output changes from a more than proportional to a 
less than proportional one, — the latter being at the tenth combination, 
the former at the sixth. As already noted, this precise location of the 
point at which the marginal product begins to decline is not neces- 
sary for every possible case in which the increase begins to be less 
than proportional at the tenth combination. In other words, our 
experiment does not prove that a locating of the change in marginal 
product at a point earlier than that at which the change in propor- 
tionality takes place is inevitable; it does prove, however, that this 
is possible, if not probable. It follows that we cannot properly 



IX] OUTPUT AND RATE OF PRODUCTION 133 

treat the two phenomena as identical. The principle that the mar- 
ginal product first increases, then diminishes, is not the same as the 
principle that output increases more than proportionally to the 
changing factor, then less than proportionally.® It should be added, 
however, that, generally speaking, we have no interest in marginal 
products prior to the ninth combination. These marginal product 
figures are useful chiefly in showing us whether or not it would 
pay to add further to the number of L's in the combination.'^ But it 
goes without saying that such is the case anyhow up to the ninth 
combination. For up to that point we are raising both averages by 
each addition of L's; and, as long as this is true, it is a matter of 
indifference whether or not each L adds as much as its predecessor. 

V 

Factor L Constant, Factor N Changing 

In our imaginary experiment as embodied in the table, the quan- 
tity of N's was supposed to be constant while that of L's increased. 
What, now, would be the result were this situation to be reversed 
with the L's constant and the N's increasing? It would be precisely 
similar to that already brought out, with the places of N's and 
L's reversed. Output would increase at first more rapidly than 
the N's, then less rapidly, then actually decrease; the average 
measured in N's would increase up to some early combination, then 
diminish to the end, while the average measured in L's would in- 
crease up to some later combination, then diminish to the end ; and, 
finally, the marginal additions, the marginal product of N's, would 
increase up to some combination prior to the ninth, then diminish 
to the end. And note that the acceptance of these statements does 
not depend on a new induction. // the points made with respect 
to the results which follow when N's are kept constant and L's 
increased are true, the analogous statements with respect to the 



*This comment seems necessary on account of occasional carelessness 
of statement on this point in the literature of our subject. 

' Many economists hold that the marginal product is also very useful 
in guiding us as to the importance or significance to the producer of the 
factor in question. 



134 PRINCIPLES OF ECONOMICS [IX 

results which follow when L's are kept constant and N's increased 
must be true. A table reversing the relations of L's and N's, in 
respect to both conditions and results, is directly deducihle from the 
table already given. Accordingly, in so far as the doctrines set 
forth in the preceding discussion apply to any particular combina- 
tion, they are true without regard to which of the factors is kept 
constant and which is increased. If they are true of a .combination 
of land and labor in which the land is constant, they are equally 
true of one in which the labor is constant. 

The point just made, that the principles laid down with respect 
to the effect of increasing one of the factors of a combination while 
the other remains constant are true whichever one of the factors is 
increased, must not be understood as implying that it is of no prac- 
tical importance which factor is taken as the constant one. Some 
natural factors in production and many produced ones necessarily 
appear in large, indivisible units. They must be utilized as a whole 
or not at all. For example, the group of great lakes beginning with 
Superior and ending with Ontario — a very important factor in 
transportation — cannot be made smaller or larger. We must use the 
system as it is. 

So a plant for lighting a great city or supplying it with water 
cannot be changed ever week or month or year. If we have to 
increase or diminish the amount of service obtained from factors 
of this type, we must for a time if possible do so by increasing the 
quantity of auxiliary factors used. Such increasing of the auxiliary 
factors is usually possible, because those factors are to be had in 
small or easily divisible units. While we cannot increase the size 
of the lakes, we can change in no great length of time the number 
of boats navigating those lakes. While we cannot at frequent in- 
tervals enlarge the whole lighting plant, we can readily increase the 
amount of labor employed or the quantity of coal consumed. 

The importance of the principles brought out in this chapter 
grows out of their application to cases like these in which one of 
the combining factors is naturally or necessarily kept constant for 
a shorter or longer period, zvhile amy or all of the others may be 
changed. 



IX] OUTPUT AND RATE OF PRODUCTION 135 

VI 
Output from Groups of Factors 

We have noted the effect on output of increasing one of the 
factors of a combination when we are deaUng with single factors. 
We have to add that the same phenomena appear when we are 
deahng with groups of factors over against one or more auxihary 
factors. Thus, when trying to ascertain the effect on output from 
the aggregation of land, buildings, machinery, etc., which we call 
a plant, of increasing the amount of auxiliary factors, raw mate- 
rials, fuel, labor, etc., we have the same general experience as before. 
For a time, the output increases more rapidly than the auxiliary 
factors, then less rapidly, then absolutely diminishes. 

The same statement would of course apply to a business unit 
as a whole, that is, a partnership or a corporation operating one or 
many plants. This would be so, partly because the plants operated 
by the corporation would exhibit the phenomena in question and 
partly because the organisation side of the business would inde- 
pendently exhibit these phenomena. While parts of the organization 
remained constant — for example, the higher officials, one president, 
one secretary, and one general manager, — other elements would be 
increased, and this increase would at some stages result in a more 
than proportional increase in output and at others in a less than pro- 
portional one. 

In general, then, it is scarcely to be doubted that we have 
here a principle or set of principles of very wide application. In 
practically all cases, we may alter the proportions in which factors 
are combined without destroying their power to produce; but we 
cannot help changing their effectiveness or productivity, making 
them produce, proportionally, more or less. And this fact will be of 
importance whenever the circumstances are such that some one factor 
or group of factors, is absolutely fixed, or, for a longer or shorter 
period, is fixed by special circumstances. 



CHAPTER X 

ATTEMPTS TO INCREASE OUTPUT AND SOME 
ECONOMIC CONSEQUENCES 

In the last chapter we explained the more immediate and chiefly 
technical consequences resulting when we attempt to increase the 
output from a factor of production by increasing the amount of the 
auxiliary factors employed. We must now remark on some remoter 
consequences, — especially some of an economic character. 



Limits of the Productive Capacity of Individual Instruments 

As noted in introducing our last chapter, one of the most im- 
portant economic problems connected with the matter we are now 
studying concerns the limits of our productive capacity. In so far 
as this inquiry has to do with the individual instrument, the most 
valuable conclusions of our study are these two: (i) There is an 
absolute limit to the amount obtainable from any instrument, and 
(2) before that absolute limit is reached, there is a stage during 
which the increase in output is less than proportional to the increase 
in the quantity of auxiliary factors. On account of its great im- 
portance, the second of these ought, perhaps, to be given the em- 
phasis derivable from its statement as a formal principle. This 
principle is commonly known as the Law of Diminishing Returns. 

Principle — The Law of Diminishing Returns. 
// attempts are made to increase indefinitely the output 
of any factor of production by increasing the quantity of 
auxiliary factors used, a time zvill come, before the absolute 
limit is reached, when, though there continues to be an 
increase in output, that increase is less than proportional to 
the increase in the quantity of assisting factors added. 

136 



X] INCREASE IN OUTPUT: CONSEQUENCES 137 

We must now add a word about certain technical phrases used 
in connection with the principle just stated: When the utilization 
of any instrument of production has been carried up to the com- 
bination which will yield only a smaller proportional return, it 
is said to have been worked or utilized to "the point of diminish- 
ing returns/' A step further takes it beyond the point of dimin- 
ishing returns or into the stage of diminishing returns. As the 
utilization of any instrument is carried further and further into 
the stage of diminishing returns, it is said to be worked (culti- 
vated in the case of land) 'intensively" or "more intensively." 
Another method of expressing the same idea is to say that "the margin 
of cultivation (utilization) is loivered" or "pushed down." 

The discussion leading up to the above statement of the prin- 
ciple of diminishing returns has, perhaps, insured its correct inter- 
pretation. In view, however, of numerous misunderstandings which 
have appeared in economic controversy, it seems best to indicate 
specifically certain misinterpretations which need to be guarded 
against. First, the "returns" referred to in the designation "diminish- 
ing returns" are physical returns, — product, not money or profits. 
The principle means that by increasing the amount of labor we 
can increase, though less than proportionally, the potatoes raised 
on a given piece of ground, or the heat given out by a furnace, or 
the freight carried by a railway, and so on. 

In order to emphasize this point, I like to call our principle 
the Law of Diminishing Output, thus avoiding the ambiguity 
attaching to the word "returns." 

Another misunderstanding confuses the principle now under 
discussion with one which says that there comes a stage in the pro- 
duction of goods when product can be increased only at increasing 
cost. This statement is without doubt true; but, as will be brought 
out in the next chapter, the condition indicated is not identical with 
the one meant when we say that we have reached the stage of 
diminishing returns. 

Another troublesome misunderstanding interprets our principle 
to mean that output could never be increased at a proportional 
rate whatever might happen, however much improvement in the 
productive arts might take place. This, of course, is a quite illegiti- 



138 PRINCIPLES OF ECONOMICS [X 

mate interpretation. A natural law in Economics, just as in 
Chemistry or Physics or Biology, assumes the continuity of condi- 
tions other than the one or more which the principle itself represents 
as changing. Doubtless any person is at liberty to affirm a principle 
analogous to the one here considered in a dynamic sense, as we 
sometimes say, that is, as certain to prove true despite changing 
conditions. But' most prudent people will hesitate to do so ; and 
anyhow, unless this is expressly indicated, the affirmation is always 
made subject to the condition that no changes are to take place 
except the one specified in the principle itself, namely, an increase 
in the quantity of the changing factor. 

Illustrative Problem 

"Malthus was quite wrong when he tried to show that at life's ban- 
quet there was room for only a limited number of guests. The guests 
are also cooks, contributing their share of the banquet." — Dr. Bertillon 
in a lecture in Paris in 1913. 

Criticize this statement of Bertillon on the basis of the law of dimin- 
ishing returns. 

II 

Elasticity of the Limit Set by the Law of Diminishing Returns 

In our formulation of the Law of Diminishing Returns, and 
too often in our interpretation of that law, all emphasis is laid on 
the fact that it acts as a check on output, — sets a limit to output. 
Only a very little thought makes it clear that this principle has 
another side. It is true that output does not increase proportionally 
to the increase in auxiliary factors ; but then output does increase. If 
we have reached the stage of diminishing returns in the utilization 
of any instrument of production, we cannot get any more product 
out of it at the same rate as before; but we can get some more. 
In fact, our principle might with very good reason be named the 
Principle of Output Increasable at a Diminishing Rate. Such a 
designation recognizes equally the fact that output can be increased 
and the fact, also, that the increase will be less than propor- 
tional. 



X] INCREASE IN OUTPUT : CONSEQUENCES 139 



Illustrative Problem 

The law of diminishing returns is a reason why the price of wheat is 
lower than it might be, and, at the same time, is a reason why the price 
of wheat is higher than it might be. Explain the seeming contradic- 
tion. 



Ill 

All Divisible Factors Usually Being Worked in the Stage of 
Diminishing Returns 

We have seen that most economic factors are subject to the law 
of diminishing returns in the sense that, in trying to utilize them 
more and more fully, a time will come when such attempts will 
increase product, but increase it less than proportionally. We now 
have to add that, under normal conditions, the utilisation of any 
divisible factor must have been carried into this stage, — producers 
must be working it in some combination beyond the point of diminish- 
ing returns. In terms of our table, any such instrument will at all 
times be working in some combination later than the ninth and 
earlier than the nineteenth. 

The general argument on which the above statement is based 
is as follows : 

All combinations earlier or later than those indicated are ex- 
cluded as being for one reason or another illegitimate. First, all 
combinations coming after the nineteenth must be excluded, since 
the additions to the changing factor which make up these combina- 
tions reduce the total, — a result which can be avoided by the simple 
expedient of not making those addit-ions. Secondly, all combina- 
tions from the first to the eighth inclusive must be excluded ; since, 
under our hypothesis that the factor under consideration is divisible, 
we could transform any one of these early combinations into the 
ninth by the simple expedient of discarding some of the N's, and, in 
doing this, would increase our total. Thus, the seventh combination, 
20 N's with 8 L's, could be transformed into the ninth by discarding 
4 of the N's, making the combination 16 N's with 8 L's, — the same 
2 to I ratio as that of the ninth. But this combination would give 



I40 PRINCIPLES OF ECONOMICS [X 

us 8 times 20 or 160 units of product, whereas the original com- 
bination of 20 N's with 8 L's would give us only 156 units. 

We have seen that, under normal conditions, no divisible factor 
would be used in any combination later than the nineteenth nor 
earlier than the ninth. That is, the actual, efifective working of 
any factor would be Hmited to some one of the 11 combinations 
from the ninth to the nineteenth inclusive. But we must narrow 
still further the range of reasonable, and so actual, combinations. 
Another element necessarily comes in to determine what ones are 
possible, namely, cost of production. If N's could be had in un- 
limited abundance for nothing, while L's had a price however 
small, the ninth combination would plainly be the most desirable, 
since it gives the highest average measured in L's, and so, when the 
price of the L's constituted the only cost, the cost in this combination 
would be lowest.^ 

On the other hand, if N's had a price, but L's none, the nine- 
teenth combination would be the cheapest, and, so, the most desir- 
able of all. But, in real Ufe, both N's and L's will have some 
cost, else they would not be economic factors at all. Further, 
there will not often be such a difference between their costs that 
either is negligible in the total cost. It follows that, if both 
factors are divisible, the truly legitimate combination will normally 
be one which comes later than the ninth and earlier than the nine- 
teenth. 

Assuming reasonable conductl on the part of producers, they 
will be using any factor in some one of the combinations indi- 
cated, — ^the combinations lying between the ninth and the nineteenth. 
But any one of these is bound to be a diminishing-returns combina- 
tion, that is, one holding such a position that, if we try to increase 
output by increasing the quantity of auxiliary factors, we shall 
effect some increase but an increase which is less than proportional 
to the increase in auxiliary factors. We conclude, then, that, in 
actual life, we should expect to find any divisible factor being 
worked in the condition of diminishing returns. 



*This would be true even if N's had a price, but one which was 
insignificant as compared with that of L's. 



X] INCREASE IN OUTPUT: CONSEQUENCES 141 



IV 

Indivisible Factors May Be Working in the Stage of Increasing 

Returns 

We have just seen that divisible factors will normally be used 
in the condition of diminishing returns, because on account of the 
divisibility of the factor which was kept constant in our experi- 
ments, we could always change to a later combination, and would 
do so if this was desirable. But, when we come to deal with indi- 
visible or large-unit factors, the problem is greatly altered. Just 
because the given factor is indivisible, we cannot adapt it promptly 
to every change in the need for product. Thus, it is plain that we 
cannot change our furnace every time the weather changes, substi- 
tuting a larger one if more heat is needed or a smaller one if less 
heat is needed. What we have to do is to run the one we have 
harder or easier, — put in coal oftener or less often. An obvious 
result of this situation is that, if the weather gets warmer, we may 
be obliged to run the furnace so low that it is being worked in 
some stage prior to the ninth, say the seventh or the fourth. This 
of course is uneconomical : we get much less heat per pound of coal 
than we might if our plant were adapted to just the need of the 
moment. But we have no choice. We must install a furnace large 
enough to meet the need of really cold weather; and yet, on a 
moderate day, we must not work it hard enough to make the house 
uninhabitable. It follows, then, that we may find any indivisible 
factor being used in the stage of increasing returns, output increas- 
able at an increasing rate. 

What we have just said of the furnace applies as well to any 
large natural factor, for example, the lake system used for illustra- 
tion on page 134. Such a factor may be working in the condition 
of increasing returns or in that of diminishing returns. Which it 
will be depends entirely on the existing need for the services of the 
factor. We have no choice in the matter. We have to use it as 
it is whether the need be great or small. For a long period while 
population was small, this vast system of waterways could be 
utilized only in some inferior combination, some one earlier than 



142 PRINCIPLES OF ECONOMICS [X 

our ninth. With the increase of population during the last fifty 
years, it probably has passed into some combination later than the 
ninth. 

The case of indivisible, large-unit factors of the producible sort 
is, naturally enough, different. We have some control of the situa- 
tion in that, when constructing such instruments, we can adapt them 
to a particular output, — make them of the proper size to supply 
this output most cheaply. But, as a matter of course, they will 
be called on to supply different volumes of output at different times. 
Naturally, the volume for which they will be planned will be that 
one which is expected to be normal. They will, therefore, be built 
on a scale which enables them to supply this normal output when 
working in the combination showing least cost.^ It follows that, 
under normal conditions, such indivisible producible factors will be 
working in that particular combination lying between the ninth and 
the nineteenth which shows least cost. If, however, the demand 
is abnormally large, they will be pushed into some later combination ; 
while, on the other hand, if it is abnormally small, they will be 
brought back into some combination lying between the least-cost 
one and the ninth, or, even, into one earlier than the ninth. 

Illustrative Problem 

In what S'tage, as respects returns, would you expect to find an auto- 
mobile plant working during an industrial depression? After business 
had revived? When a boom was on? 

V 

The Diminishing Marginal Significance of Factors 

One more important fact which in part anyhow grows out of our 
effort to increase output by increasing the quantity of the auxiliary 
factor used, is suggested by the title of this section : "The Diminish- 
ing Marginal Significance of Factors." In general the different 
units of any particular kind of factor can be put to uses having 



'They will probably be built on a little larger scale than this in anticipa- 
tion of increasing need. 



X] INCREASE IN OUTPUT: CONSEQUENCES 143 

different degrees of importance or significance. When such uses 
are wholly distinct, this proposition is evident enough. Thus, in 
time of war, the food supplied to the soldiers in the field plays a 
more important role than that destined for the ordinary civilian ; 
and the steel used in making ammunition is more significant than 
that devoted to making pleasure cars. Even if the different uses 
have to do with one product, the case is scarcely less plain. Thus, 
the steel used in the corn farmer's plow is more important than that 
used in his spring-toothed harrow; without the former he could 
scarcely farm at all, the latter he might dispense with rather easily. 
Finally, different uses of the same factor differ in importance or 
significance even when the factor is operating in just the same way. 
Thus, if, under similar conditions, a cultivator goes over a cornfield 
several times, the importance of the service it renders will be smaller 
as the number of times increases. This, manifestly, is merely a 
special application of the principle of diminishing marginal produc- 
tivity brought out in the preceding chapter. 

But, not only may the different uses to which a given factor is 
put vary greatly in importance or significance, among these different 
significances there is one which plays a much more important role 
than the rest. That one is the smallest or least of them all. Thus, 
if we have steel enough so that we can afford to use it for both the 
plow and the spring-toothed harrow, the significance of the steel 
used in the harrow will play a more important part than will the 
significance of the steel used in the plow. The former rather than 
the latter will determine the estimate we put on the importance of 
the amount of steel necessary to make a plow or a harrow.^ The 
reason is not far to seek. Our estimate of the importance of 
anything — in this case the quantity of steel necessary to make either 
a plow or a harrow — depends on how much loss we should experience 
if we had to give it up. But, if we had to give up either the plow 
or the harrow, the one chosen for the sacrifice would, of course, 
be the harrow, the less important of the two. The significance lost 
to us, therefore, would be the lesser significance; and, hence, the 



'As we shall learn later, this estimate will have a part in determining 
the value or price of steel. 



144 PRINCIPLES OF ECONOMICS [X 

estimate which we make of the importance of steel would be deter- 
mined by the lesser significance. Broadening the statement so as 
to cover the whole stock of steel, we say that the estimate we make 
of the importance of steel would be determined by its significance 
in the least important use, — its least significance. 

This least significance of any factor which is of much importance 
in economics, we designate its marginal significance. The designa- 
tion signifies that this particular significance is located at the 
boundary line separating the significances which are realized from 
those which are not. 

We have seen that the diflferent significances of any factor are 
quite unequal, and that one of these, the marginal significance, is 
of great moment in economic matters. We must now add a proposi- 
tion which we will call the Law of Diminishing Marginal Sig- 
nificance. 

Principle — The Law of Diminishing Marginal Signi- 
ficance. 

Generally speaking, the marginal significance of any 
factor tends to diminish as the quantity of that factor 
available increases. 

The marginal significance of a particular kind of land will be 
much smaller if there are millions of acres of such land available 
than it would be if there were only hundreds. As between different 
kinds of land, the marginal significance of the kind of which there 
are only hundreds of acres will very likely be greater than the 
marginal significance of a kind of which there are millions of acres, 
even though the generic significance of the latter kind is much 
greater. 

That things are bound to work in a way to make the above 
proposition true is easily seen. Assuming the general rationality 
of business conduct, the uses to which any factor has not as yet 
been put will be less significant than those to which it has been put. 
It follows that, if new supplies of that factor are forthcoming, they 
can be utilized only by assigning them to uses which have less sig- 
nificance than those already provided for. Hence the principle. 



X] INCREASE IN OUTPUT: CONSEQUENCES 145 

Illustrative Problem 

Assuming that laborers of any class tend to get a price for their 
services — wages — representing substantially the marginal importance of 
their type of service, show that you would naturally expect restrictions 
on immigration to raise wages in the United States. 



CHAPTER XI 

INCREASE IN OUTPUT AND COST OF PRODUCTION 

A very important topic closely connected with the one which has 
occupied the last two chapters is the effect on cost of production 
caused by attempts to increase the volume of output. This problem 
really breaks into two parts: (i) what will be the effect on cost 
of trying to increase output from a particular instrument or group 
of instruments fixed in amount, and (2) what will be the effect 
on cost of trying to increase the output from a particular industry 
as a whole, with no restriction on the quantity of any instrument 
or factor. We begin with the former of these problems. 



The Effect on Cost of Trying to Increase Output from a Partic- 
ular Instrument or Set of Instruments Fixed in Amount 

Interpreted as asking what will be the effect on cost of trying to 
increase output from a single instrument or set of instruments 
fixed in amount, our new problem is very close to that treated in 
Chapter IX. In fact, if we mean by cost only the expenditure for 
the factor which increases, the two problems are one, looked at from 
slightly different points of view. Under the conditions named, to 
say that a plant or a business is in the condition of diminishing 
returns would amount to the same thing as to say that it is in the 
condition of increasing cost. But, in actual business, we have 
usually no interest in particular factors unless they are economic 
ones, that is, unless they are factors having prices. We have, 
therefore, to remember that in the real world we shall have to pay 
for N's as well as for L's. The total cost, therefore, will not change 
merely with the change in output as measured in L's; it is bound 
to be influenced by the changes in output as measured in N's also. 

146 



XI] OUTPUT AND COST 147 

But, though different, the two problems are very closely connected ; 
and the solution of the one treated in Chapter IX plays a large part 
in the solution of the new one. 

Our first task is to consider the effect on cost of trying to in- 
crease output from simple combinations like those made up of our 
N's and L's. The solution is not difficult, though the explanation 
must be followed with some care. First, the cost per unit of product 
for any particular combination must equal the cost per unit measured 
in N's plus the cost per unit measured in L's. For example, if in 
a given combination the average output measured in N's is 10 units 
and each N costs $1, so that the cost of each unit measured in N's is 
$1 over 10 or 10 cents, and, if that same output measured in L's gives 
20 units per each L while each L costs $1, so that the cost of 
each unit of product measured in L's is $1 over 20 or 5 cents, then, 
the total cost of each unit of product must be 10 cents plus 5 cents, 
or 15 cents. 

Secondly, the cost per unit measured in either N's or L's must 
increase as the average output measured in that factor diminishes, 
and must diminish as the average measured in that factor increases. 
For example, if the average output in N's increases from 10 to 20 
units, when each N costs $1, then the cost per unit, measured in N's, 
falls from 10 cents to 5 cents. On the other hand, if the average 
measured in N's diminishes from 20 to 10, the cost of each N being 
$1, the average cost, measured in N's, rises from 5 cents to 10 cents. 

Cost Measured in Each Factor. — Again, since the average 
measured in N's is increasing from the second combination to the 
nineteenth, while that average diminishes from the twentieth on, 
the cost, measured in N's, must decline from the second to the nine- 
teenth combination and must increase from the twentieth on. On 
the other hand, since the average, measured in L's, increases up to 
the ninth combination and then diminishes to the end, the cost, 
measured in L's, must diminish up to the ninth combination and 
thereafter increase to the end. Further, since the increase in the 
average measured in N's is rapid during the first few combinations 
after the ninth, and becomes slow as we approach combination 19, 
the cost in N's declines rapidly during the earlier combinations after 



148 PRINCIPLES OF ECONOMICS [XI 

the ninth and slowly during the later ones. In like manner, the cost 
in L's, though increasing up to the nineteenth combination, does this 
slowly during the earlier combinations after 9, speeding up as we 
approach the turning point at 19. 

Cost Measured in Both Factors. — The last two paragraphs 
have shown us the course followed by the cost of production as 
measured in one or the other of the factors taken separately. It is 
now easy to see how the total cost per unit, that is, the cost measured 
in both factors must behave. Since cost, measured in either factor, 
diminishes up to the ninth combination, the average of the total cost 
must diminish up to that same combination. Again, since the average 
cost, measured in either factor, increases after the nineteenth, the 
average of the total cost must increase after the nineteenth. This 
statement disposes of the first and last 8 combinations. What, now, 
is to be said with respect to the remaining 11? First, in so far as 
the cost for any one of these is influenced by the cost measured in 
N's, that cost will tend to diminish clear up to the nineteenth com- 
bination, since the cost measured in N's diminishes up to that com- 
bination. 

On the other hand, in so far as the average of the total cost 
is being influenced by the cost measured in L's, it will tend to 
increase from the ninth combination on, since the cost measured in 
L's increases from that point. That is, we have here two opposing 
tendencies, a downward one due to the influence of N's and an 
upward one due to that of L's. 

But, again, the opposing pulls of N's and L's are not uniform 
throughout their course.^ Instead, the upward pull on costs exer- 
cised by L's is relatively small in the earlier combinations after 
9, but rapidly increases as we approach 19. So likewise, the down- 
ward pull of N's is great in the earlier combinations after 9 but 
weakens as we approach combination 19. J'rom these facts it 
follows that the general trend of the total average is downward 
during the earlier combinations, upward during the later ones. But, 



* If they were, the resultant tendency might be a constant cost between the 
ninth and nineteenth combinations, or it might be a least cost at the ninth 
or a least cost at the nineteenth. 



XI] OUTPUT AND COST I49 

since there must be a turning-point between these two opposite 
trends, one or at most two ^ of the combinations must show a lower 
cost than the others, a least cost. In short, for any particular pair 
of prices for N's and L's, we are bound to have results like this : 
(i) during a shorter or longer series of combinations, cost will de- 
cline; then (2) a least-cost combination^ will appear; and (3) dur- 
ing a longer or shorter series, cost will increase. 

The Least-Cost Combination. — What, now, is to be said with 
respect to the location of the least-cost combination? In general, 
this must depend on the relative prices of N's and L's. As we have 
already seen, the influence of N's must tend to lower cost with 
every movement toward combination 19, while the influence of L's 
must tend tO' lower cost with every movement from 19 toward 
9. It follows that thq least-cost point will tend to move toward 
19 under the influence of N's and toward 9 under the influence 
of L's. 

Which of these opposing forces will outweigh the other depends 
upon their relative magnitude, that is, the relative magnitude of the 
prices which the producer has to pay for N's and L's, If N's are 
very costly, this will tend to push the least-cost point toward the 
nineteenth combination, and vice versa. If, for example, N's cost 
$1 each and L's 40 cents each, the seventeenth combination will be 
the cheapest; while, if N's cost 20 cents and L's $1, the eleventh 
combination will occupy this place. 

Least Cost and Diminishing Returns. — The foregoing dis- 
cussion would seem to clear up pretty fully the problem of cost 
as affected by changes in combining proportions. Before going on, 
however, we ought, perhaps, to contrast this problem of changing 
costs ivith that of changes in output as affected by changes in com- 
bining proportions. As we have seen, the principle that output tends 



* When, through the falling of the price of L's, the point of least cost 
is about to pass from one combination to the next lower, one particular 
price for L's will make cost in the two combinations just the same, though 
a slight decline in that price would move that point into the later combina- 
tion and a slight advance would put it back into the earlier one. 

^ Or pair of combinations. 



150 PRINCIPLES OF ECONOMICS [XI 

to increase less than proportionally is the same as the proposition 
that cost tends to increase, only on condition that we are measuring 
cost in the changing factor. This point, brought out more sharply 
now that we are clear as to the behavior of total cost, means that 
the turning-point from the preceding stage to the one under con- 
sideration occurs in a different combination in the two cases. For 
example, in our series of supposed combinations, the output is in- 
creasing more than proportionally up to combination 9, after which 
it increases as far as combination 19 less than proportionally; that 
is, for output, the ninth combination is the turning-point. As we 
have just seen, however, the turning-point for cost is practically 
always a combination later than the ninth. If we suppose the price 
of each of the factors to be just $1, the turning-point, the least-cost 
combination, proves to be combination 14. Further, as was fully 
explained, this turning-point varies with every considerable change 
in the relative prices of the two factors. In short, instead of being 
at the same combination as the one at which diminishing returns 
sets in, it almost never occupies this place, and it may theoretically 
be in any one of the 11 combinations from the ninth to the nine- 
teenth, inclusive. This point needs some emphasis, because not a 
few writers have carelessly identified the principle that, after a 
certain point, the proportional returns diminish, with the principle 
that, after a certain combination is reached, cost of production begins 
to increase. 

We may add, as an application of the distinction between these 
two principles that in any particular case of the utilization of a factor 
of production, we may have passed the point of diminishing returns 
and yet not have reached the point of increasing cost. For example, 
if our N's represent a furnace used in the heating of a house, and 
if the combination which gave out the largest amount of heat per 
unit of cost was the 13th, then, if we were actually using the furnace 
in the nth, we should be using it in a stage earlier than the least- 
cost stage, but not earlier than the diminishing-return stage. If, 
however, the day was very mild and we were using the furnace in 
the seventh combination, we should be working it in a stage 
which was earlier than the diminishing-return one as well as earlier 
than the least-cost one. 



XI] OUTPUT AND COST 151 

Illustrative Problem 

It is possible to be using a I'ailroad plant in such a condition that, if 
we could increase the traffic a certain amount, we could increase the re- 
turn per unit of the assisting factors, and so diminish the cost. But we 
might also be working that plant under such conditions that, though we 
could no longer increase the return per unit by increasing traffic, we 
could, after all, diminish the cost of production. 

Explain how this could be. 

Least Cost Seldom Realized. — One other point needs a 
moment's comment before leaving this matter of least cost. At first 
thought we might suppose that, in using any group of factors, we 
should always put them together in the proportions giving the least- 
cost combination. As a matter of fact, however, we should rather 
seldom be able to do this. In almost all situations we have a body 
of factors which are relatively fixed over against a set which are 
constantly changing in quantity, the former being designated fixed 
capital, the latter circulating capital.* Now, in the nature of things, 
the former cannot be nicely adjusted to every change in the volume 
of output. Any plant will naturally be planned and built on such 
a scale that, when supplying its normal output, it will be working 
in the least-cost combination.^ But when a volume of output smaller 
or greater than this is temporarily called for, it will become neces- 
sary to work the plant in a combination earlier or later than the 
least-cost one. That is, it may be necessary and proper, much of the 
time, to be working a plant in the diminishing-cost stage or the in- 
creasing-cost stage, rather than in the least-cost stage. This of 
course requires that the price of the product should be high enough 
to justify the producer in using a combination more expensive than 
the least-cost one. 



* Costs growing out of fixed capital are often called overhead costs, those 
connected with circulating capital are called prime or out-of-pocket 
costs. 

' This statement needs qualification because of the fact that it will usually 
be thought best to plan for future growth of demand; so that the plant 
will more usually be built on such a scale that, for a time, it will normally be 
working in a stage somewhat earlier than the least-cost stage. 



152 PRINCIPLES OF ECONOMICS [XI 

What has been said of a plant can with equal truth be said of a 
business unit as a whole. Here, as before, the plant or group of 
plants run by the concern will sometimes be working in a stage 
earlier than the least-cost combination, or just at that combination, 
or later, — in the first case, being in the condition of diminishing cost, 
in the second and third cases being in the condition of increasing 
cost. In addition, similar statements may be true with respect to the 
organization side of the business unit or company. The force of 
general officers, and of departmental superintendents, may be work- 
ing in a condition of diminishing cost or one of increasing cost. 

Finally, it would seem that the propositions which have been 
laid down with respect to single instruments, plants, and business 
units, may be affirmed with respect to social groups, districts, coun- 
tries, even the world. Broadly speaking, any one of these totalities 
may at any moment be in such a condition that an effort to increase 
the aggregate of economic goods in order to satisfy the needs of a 
larger population would result in a diminishing expenditure of 
human effort and natural resources, or just the reverse. In the 
former case, the community under consideration would not have 
carried the utilization of its outfit of natural resources to the least- 
cost combination, though it might have carried that utilization be- 
yond the point of diminishing returns. And an increase in popula- 
tion calling for a larger output of products and furnishing a larger 
supply of human productive power would enable the community 
to carry the utilization of its natural resources into a less costly 
and so more desirable stage. If, however, the community had 
already reached or even passed beyond the least-cost stage, the in- 
crease in population could only result in driving the industry into, 
or further into, the stage of increasing cost, and so, from our present 
point of view, could only result in harm. 

Illustrative Problems 

I. If the demand for a certain manufactured commodity is very 
small indeed, the cost per unit is likely to be larger than it might be. If 
the demand for that commodity becomes enormously great, the cost is 
again likely to be larger than it might be. Explain how both these state- 
ments can be true. 



XI] OUTPUT AND COST 1 53 

2. "I am disposed to think that, up to 1900 anyhow, the United States 
was under- rather than over-populated." 
Explain how this could be. 

II 

The Effect on Cost of Trying to Increase the Output from an 

Industry as a Whole, There Being No Restriction on 

the Quantity of Any Instrument Used 

We now pass to the second phase of our problem — the effect 
on cost of trying to increase the output from an industry as a whole. 
What will happen to cost, if we try to get more copper from the 
copper industry, or more wheat from the wheat industry, or more 
automobiles from the automobile industry? Will the cost per unit 
remain the same as before or become larger or smaller than before? 
This question, like our original one, breaks into two. (1) What 
will be the immediate effect on cost in a given case? In other 
words, in what stage is an industry at this moment, diminishing 
cost, constant cost, or increasing cost? (2) What will normally 
be the effect in a given industry? What effect is characteristic of 
that industry? In which of the three stages is that industry likely 
to be most of the time ? 

Theory of Cost Variation. — In order to answer these ques- 
tions even briefly, we need to have in mind the principal causes 
which tend to affect the cost of production as output is increased. 
Of these there are three. The first cause to be considered is the 
condition of the durable instruments already being used in the in- 
dustry in question. Are those instruments being worked in the 
stage of diminishing cost, or minimum cost, or increasing cost? 
Their condition in this respect, in so far as they are able to influence 
the matter at all, will obviously tend to establish a like condition 
for the industry as a whole. A second cause affecting cost is the 
degree of difficulty experienced in duplicating the instruments em- 
ployed in an industry. Will the new machines, the new labor, and 
the new land needed to expand output cost the same as, or more 
or less thaUj our present stock cost us ? The third cause is the degree 



154 PRINCIPLES OF ECONOMICS [XI 

to which the industry is able to realise the advantages of large-scale 
production set forth in an earlier chapter. The possibiHty of using 
large-scale methods must of course tend to put the industry into the 
condition of diminishing cost ; and the extent to which these methods 
can be used must determine largely how potent they will prove. 

Now, when we ask concerning the immediate condition of an in- 
dustry, the potency of these three causes above enumerated depends 
chiefly on two considerations: (i) the state of industry in general, 
and (2) the nature of the particular industry involved. 

First, to begin with the former of these two considerations, any 
particular industry is likely to be in the condition of diminishing cost 
when business is depressed, in that of increasing cost when business 
is booming, and in that of constant cost when business is in a state 
lying between these extremes. The reasons are evident. The de- 
pression means that demand for products is small and prices are low. 
In consec^uence, an attempt to increase output in response to increas- 
ing demand would find the situation advantageous in respect to each 
of the three causes enumerated above. First, the fixed capital of the 
industry would be working in a condition of low efficiency or high 
cost, and the expansion of output would enable producers to utilize 
that fixed capital in a more efficient, less costly stage. Again, the low 
prices of a period of depression would make the factors necessary for 
expansion more than ordinarily cheap. Finally, the increase in out- 
put would open the way for a fuller utilization of large-scale methods. 
All this would obviously be reversed at the height of a boom. Fixed 
capital would be working beyond the point of highest efficiency ; the 
cost of factors would be very high ; the advantages of large-scale 
methods would already have been utilized to the full. Finally, in the 
period between these extremes, these opposing tendencies would 
come to something like an equilibrium in which expansion of output 
brought neither less nor greater but the same cost. 

But, again, the effects produced by our three causes would be in- 
fluenced by the nature of the industry in question. The influence of 
the possibility of getting more services out of fixed capital, of carry- 
ing that capital forward to the point of minimum cost, would signify 
little in the case of an industry which used little of this type of capital, 
— say retail trade — but much in an industry such as mines and steel 



XI] OUTPUT AND COST 155 

mills, which used a great deal. Similar differences would show in 
the influence exerted by the cost of the factors necessary to expan- 
sion. The industries utilizing a large amount of fixed capital and 
a relatively small amount of new factors would naturally be less 
affected by the increase in cost of the latter. The smaller the out-of- 
pocket expenses, the smaller the significance of this element. Thus, 
farming is not affected as favorably as many other lines of industry 
by the low prices of supplies prevailing in a period of depression nor 
as unfavorably by the high prices of those supplies characteristic of 
the top of a boom. Finally, the power to utilize the advantages of 
large-scale production varies greatly in different industries. In farm- 
ing, for example, that power is proverbially low. The necessary 
operations are very diversified and there is little repetition of opera- 
tions which duplicate one another ; the fundamental factor in this 
industry, the land, is also diverse in character, one part of a farm 
being fit for one purpose and another fit for another purpose ; and, 
finally, the necessity for rotation of crops compels frequent changes 
in product and method. All these causes, taken together, make high 
specialization in agriculture imprudent where it is not impossible. 
Accordingly this industry and others of a similar kind are less in- 
fluenced in respect to costs by the general business situation. Their 
variation in cost as output expands is less considerable than in the 
other cases. 

Characteristic Tendency. — The foregoing discussion has in a 
large measure anticipated what we need to say concerning our second 
question : what is the normal tendency of cost in a particular industry 
as output is expanded, or what tendency is characteristic of that in- 
dustry? The answer manifestly has little relation to temporary busi- 
ness conditions, being almost entirely a matter of the nature of the 
business itself. 

The significance of the first of our three causes — the condition 
of the durable instruments already being used in the industry under 
consideration — is obviously dependent on the extent to which such 
instruments are commonly employed in that industry. As compared 
with railway transportation, farming makes relatively small use of 
durable instruments, — fixed capital. Naturally, then, the presence 



156 PRINCIPLES OF ECONOMICS [XI 

of unused capacities in its durable instruments will be of much less 
potency to hinder farming from being in the condition of increasing 
cost, than it would be to keep railway transportation out of that con- 
dition. This cause, however, is apparently less effective in fixing the 
character of an industry than the next one to be mentioned. 

As respects the influence of the second cause — the difficulty ex- 
perienced in duplicating instruments — this naturally turns on the ex- 
tent to which the industry in question is dependent on natural factors. 
Those factors are absolutely limited in amount, instead of being sus- 
ceptible of increase like capital and labor services. If, then, they form 
a very large part of the necessary equipment of a given industry, for 
example, stock-raising, that industry will naturally pass into the con- 
dition of increasing cost sooner than one of which this is not true, 
for example, the manufacture of textiles. It follows from the above 
considerations that the extractive and agricultural industries are much 
more likely to be in the condition of increasing cost than manufacture 
or commerce. The narrower the field from which the natural factors 
can be drawn, the greater force will this cause exert. It will be felt 
much more in the producing of citrous fruit than in the producing of 
wheat and potatoes ; more in platinum mining than in copper mining ; 
more in copper mining than in iron mining. 

Finally, as to the influence of the third cause, an industry that 
consists largely of many similar or identical operations, and can 
therefore apply methods of large-scale production, will tend to be in 
a condition of constant cost, or even of diminishing cost. Manu- 
factures are conspicuously of this type, and agriculture*conspicu- 
ously not. 

Looking back over this discussion, we see that all the different 
causes combine to hinder manufacturing from being in the condition 
of increasing cost, and to keep it in a condition of constant or dimin- 
ishing cost. The manufacturing plant ordinarily has a large store of 
unused utilities; it depends relatively little on natural resources; 
and it is well adapted for the employment of large-scale methods. On 
the other hand, agriculture tends just as strongly, under the influence 
of all these causes, to be in a condition of increasing cost. It will 
seldom have any great volume of unused utilities to put it into the 
condition of diminishing cost; the natural factors play a large part 



XI] OUTPUT AND COST 157 

in its operation; and the chance of employing large-scale methods 
is very slight. In the mining or extractive industries the result is 
much the same although the operation of the different causes is a 
little different. The mining industries make extensive use of fixed 
capital, hoisting machinery, machinery for crushing the rocks, facili- 
ties for transportation, etc. On this score we might be led to think 
of these industries as diminishing-cost industries or even constant- 
cost. And in fact when a new grade of mine has become available by 
a rise in price the industry is likely to be temporarily in the condition 
of constant cost. That is, it will be possible for a time to expand 
output far beyond the expansion of demand without any new increase 
in cost. This particular element, mining has in common with manu- 
facture. Nevertheless, the former industry naturally shows in gen- 
eral the same tendency as agriculture because of the influence of 
the second cause which we originally named. That is, the dependence 
upon natural factors is so great that the relative difficulty of obtain- 
ing these factors in the productive process offsets the advantage de- 
rived from the former element. 

We have just seen that the prevailing or normal tendency of the 
extractive and agricultural industries is to be in the condition of in- 
creasing cost; while that of the manufacturing industries is to be 
in the condition of constant cost. Not unnaturally economists are 
wont to classify the former as increasing-cost, the latter as constant- 
cost, industries. Further, as will appear in a later connection, this 
distinction among industries is of great importance in connection 
with the determining of price. A firm grasp upon the distinction is 
therefore of much importance. Remember, however, that in using 
this classification the economist does not mean to imply that an in- 
dustry of either type is always and necessarily in the class indicated, 
but only that this is, in general, its proper classification. At times, 
it may be temporarily in the other class. 

Summary. — Summarizing the chief results of the preceding 
discussion we may set forth in conclusion the following propositions : 

(i) Any industry may be at some time or other in each one of 
these three stages : diminishing cost, constant cost, and increasing 
cost. 



158 PRINCIPLES OF ECONOMICS [XI 

(2) Most industries are likely to be in the condition of dimin- 
ishing cost if the demand for their product is so small that an increase 
in that demand would enable the industry to pass from small-scale 
to large-scale methods. 

(3) Most industries may be for considerable periods in the con- 
dition of constant cost whether their general classification is in dimin- 
ishing cost or increasing cost, because of the fact that at any particu- 
lar level of' cost there is possible an increase in output which is very 
large as compared with the expansion of demand. 

(4) Practically all industries must some time reach the stage 
of increasing cost. 

(5) In general the agricultural and extractive industries natur- 
ally classify as increasing-cost industries. 

(6) In general manufacturing industries classify as constant- 
cost industries. 

Illustrative Problems 

1. "Taken by and large, the mining of copper is probably an increas-' 
ing-cost industry." Defend that statement. 

2. Argue for the reasonableness of the proposition that, if the 
marginal cost of producing copper should rise from, say, 20 to 25 cents 
per pound, at the latter figure this industry would probably be for a 
time a constant-cost industry. 

3. Give some reasons for believing that railway transportation is 
likely to be much of the time in the condition of diminishing cost. 

4. An industry like the making of surgical instruments is likely 
to be in what condition as respects the relation between cost and volume 
of output? Explain. 

5. Suppose that, while competition in the industry is still maintained, 
the conditions of production for a particular type of wooden chair are 
such that, if fewer than 1,000 chairs a year are produced, the cost per 
chair will be about $3; that, if output is between 1,000 and 20,000, cost 
will be about $2; that if it is between 20,000 and 50,000, cost will be 
$1 ; if between 50,000 and 500,000, 50 cents; if between 500,000 and 
2 millions, 30 cents; if between 2 millions and 3 millions, 40 cents; if 
between 3 and 4 millions, 55 cents; if between 4 and 5 millions, 75 cents; 
if between 5 and 6 millions, $1.25; and so on. 



XI] OUTPUT AND COST 159 

(a) Suppose that in the year 1918, 700,000 of these chairs are pro- 
duced; that by 1920 the output has increased to 1,300,000; that by 1925 
the amount is 1,600,000; and that by 1940 it is 1,800,000. To what class 
of goods would these chairs belong during the period of 1918 to 1940, 
looked at as a whole? 

(b) Suppose that between 1950 and 2000 the output should increase 
from 2,300,000 to 6 millions. To what class of goods would these chairs 
belong during that 50 years, looked at as a whole? 

6. During the great boom in the prices of farm products character- 
istic of the war period, farmers who heard comments by other classes on 
the point were wont to say : "But look what prices we have to pay for 
all sorts of supplies, seed, fertilizer, binding twine, labor, etc. This in- 
crease in costs makes big prices necessary." Criticize that reasoning. 



CHAPTER XII 

MONEY EXCHANGE 

With the present chapter we begin the study of what has often 
been treated as one of the main divisions of economics, namely, 
Exchange, a division of our subject which, broadly interpreted, in- 
cludes nearly all the most important topics of the science. The 
starting point of this study is found in the fact already emphasized 
in our first account of the present economic order that, under that 
order, we obtain the goods which are necessary to the satisfying of 
our wants and which, generally speaking, have to be produced, not 
by producing those goods ourselves, but by devoting ourselves to 
producing something which our neighbors want and using these to 
get from others through exchange the goods which we need. It fol- 
lows that exchange is the very central, pivotal, fact in our whole 
economic order ; every other fact and circumstance is directly or 
indirectly affected by it ; and every aspect of the exchange phenome- 
non may therefore reasonably be expected to repay the most care- 
ful inquiry. 

The most important topic naturally included under the division, 
Exchange, is value and price in their various aspects, their nature, 
function, the principles or natural laws determining them, etc. Our 
first duty, however, will be to give some account of the more con- 
crete side of exchange, at least of those aspects of exchange with 
respect to which there is need for more information than is commonly 
possessed by the student when beginning the study of economics. Of 
these matters, the first one taken up in this and the next chapter 
following is the mediation of exchange, the effecting of exchange 
through a middle term. From this standpoint we distinguish two 
principal exchange processes : (i) Money Exchange and (2) Credit 
Exchange. In the present chapter we take up the former — Money 
Exchange. 

160 



XII] MONEY EXCHANGE i6i 



The Nature of Money Exchange 

Inconveniences of Barter. — Although the facts of money ex- 
change are famiHar enough to everyone, their essential nature and 
the causes lying back of them demand a moment's examination. The 
beginnings of exchange, as found in primitive societies, have always 
taken the form of barter — the direct exchanging of goods for goods. 
A man who has grain to spare and wants a canoe, gets into communi- 
cation with a neighbor who has canoes to spare and wants grain, and 
a mutual transfer is effected. But this method, even in the most 
favoring conditions, is highly inconvenient. The man who has pro- 
duced a surplus of grain which he wishes to exchange for a canoe is 
obliged first to seek out someone who has a canoe to dispose of and 
at the same time needs grain and who, further, needs grain in an 
amount exactly corresponding to the value of the canoe. 

But this necessary coincidence between exchangers as respects 
the kinds and amounts of goods wanted and offered can exist but 
rarely, and, where it does exist, can be discovered only after laborious 
searching. It would not be hard to find men who want grain ; but 
they may have no canoes to dispose of. So, it would be fairly easy 
to find men who have canoes to sell ; but they may not want grain ; 
or, if any one of them does want grain, he may want only half as 
much as would be needed to pay for a canoe. As civilization ad- 
vances these obstacles to barter become more and more serious. 
Occupations, tastes, and incomes grow more diverse, and a larger 
and larger number of workers produce things which, being unfitted 
to satisfy their own wants, must be exchanged, but which at the same 
time are wanted by only a few other individuals, and those perhaps 
widely scattered. For such persons — ^that is, for most of us — ex- 
changing their own products directly for all the different kinds of 
goods they require would be entirely out of the question. For a 
manufacturer of steel rails or mowing machines or microscopes or 
surgical implements to go about trying to obtain, in trade for these 
wares, sugar or flour or a suit of clothes, would be not merely in- 
convenient but futile. 



l62 PRINCIPLES OF ECONOMICS [XII 

Mediated Exchange. — But no highly developed society tries, 
or ever did try for long, to conduct its exchange on the barter plan. 
In the earliest trade of which we have any record, men were already 
making use of a medium of exchange — some go-between which each 
one obtained in exchange for his own goods and, when he had ob- 
tained it, used to buy other goods. The exchange medium consists 
of some concrete good of such a nature that we can readily add to, 
or take from, the amount used, so as to make up an amount exactly 
equal in value to the object we wish to buy. With the assistance of 
such a medium, the troubles of the man who has grain to dispose of 
and wants a canoe quickly disappear. He simply sells his grain to 
the different persons who want grain, they giving him from their 
easily divisible store exactly as much of the exchange medium as the 
grain is worth ; and then, taking to a canoe maker the medium thus 
obtained, he pays over as much of it as is necessary to purchase a 
canoe. 

Various Functions of Money. — Exchange, then, is mediated 
by money, and wherever the money institution exists its principal 
function is to serve as the medium of exchange. It perhaps ought 
to be remarked in passing, however, that j'ust because money is the 
medium of exchange, it almost inevitably takes on other functions. 
It serves, for one thing, as a measure of value. Being exchanged 
against all other goods, it naturally becomes the thing in which the 
values of all other goods are computed and expressed. It sometimes 
performs this function even when not actually called upon to serve 
as the middle term in exchange, as for example when two people 
estimate the value of their respective goods in terms of money, and 
yet proceed to exchange them directly, barter fashion. In fact, the 
value-measuring function of money often exists quite independently 
of its exchange function, and often seems of almost equal im- 
portance. Again, money or its equivalent, bank credit (which comes 
up for treatment in the next chapter), serves as a medium of accumu- 
lation, the instrument through which accumulations of capital are 
immediately effected. Closely allied to this last is its service as a loan 
medium since, as we know, the man who borrows capital must usually 
obtain it first in the form of money or bank credit. Money is also 



XII] MONEY EXCHANGE 163 

Utilized as the legal means of payment, in the discharge of taxes, 
fines, etc. Finally, in backward countries it is much employed, along 
with precious stones, as a storer of wealth by men who, seeking to 
save their property from robbers or tyrannical governments, turn it 
into these easily concealed forms. Various other functions of money 
could doubtless be distinguished in a fuller analysis. The central 
one, however, the one with which we are chiefly concerned in this 
course, and hence the only one calling for more than passing mention, 
is to serve as a medium of exchange. 

In the earlier forms of exchanging society, the exchange medium 
or go-between was always some use-commodity, that is, a commodity 
which people generally wanted for some purpose to which it could be 
put directly, as for example, cattle, hides, tobacco, lumps of salt, or 
cubes of tea. But, with the passage of time and the increase of 
wealth, people got in the way of using as their medium of exchange 
something specially manufactured and set apart for this function. 
It is only when this stage is reached that we can properly talk about 
money; for by money we mean an instrum^ent specially made for, 
and adapted to, the work of mediating exchange, and to those other 
tasks naturally performed by the exchange medium. 

For many centuries after its introduction, the money of even the 
most advanced countries was little more than an aggregation of 
rather crude coins of very few varieties or sizes. But with the prog- 
ress of industrial society, the money of each country has come to 
constitute an elaborate system containing many different kinds of 
money adapted to the performance of different functions, and all 
more or less perfectly co-ordinated into a coherent, self -consistent 
whole. We must now explain the principal features of such a 
system. 

II 

The Monetary System 

The Denomination System. — The first element to be re- 
marked in the American or any other monetary system is the scale 
of denominations, the names employed for expressing quantities of 
money. The need for some means of doing this is easily seen. The 
use of money to effect exchanges or measure values plainly requires 



l64 PRINCIPLES OF ECONOMICS [XII 

that we should be able to express quantities of money. But this 
means, as in similar cases, that we should have some unit or units for 
doing this, — some name or names which every one recognizes as 
meaning certain definite quantities. Such names are commonly 
designated "denominations." It would doubtless be possible to get 
along with just one of such denominations; but, on account of the 
great differences in the quantities of money which we need to make 
up for different purposes, it is obviously much more convenient to 
have a variety of such denominations, ranging from very small to 
very large ones. These different denominations usually differ by 
some convenient ratio, and form a coherent system of denominations. 
The different denominations in such a system are naturally dis- 
tinguished as Primary and Secondary. The primary denomination, 
more often called the monetary unit, is fundamental in the system, 
the other denominations being referred to it in defining their quan- 
tity. The precise significance of this statement is best explained by 
comparison with an analogous case, the unit of liquid measure. The 
gallon constitutes this unit, and other quantities are described as 
fractions or multiples of a gallon : thus a quart is a fourth of a gallon 
and a pint one-eighth of a gallon; thirty-one and one-half gallons 
make one barrel, and sixty -three gallons (two barrels) makes one 
hogshead. Similarly, in the American monetary system the unit is 
one dollar, and all secondary denominations are regarded as frac- 
tional parts or multiples of the dollar. The cent is a hundredth of a 
dollar, the dime a tenth of a dollar, the twenty-five cent piece a quarter 
of a dollar, the half-eagle five dollars, and the eagle ten dollars. In 
other countries, these denominations are different from the American 
and usually from those of any other nation ; but in all of them some 
kind of denomination system exists. 

The Monetary Standard. — The second essential element in a 
monetary system is the monetary standard. The special office of the 
standard is to fix the meaning or value of the monetary unit. For 
purposes of explanation, let us again refer to the analogue of liquid 
measure. As we all know, there exist at the present time thousands 
of liquid containers treated as gallon measures. Obviously it is quite 
possible that these should be unequal in capacity, so that, if we were 



XII] MONEY EXCHANGE 165 

to measure a given amount of some liquid in one of these measures, 
we should get one result; if we used another of these measures, we 
should get another result ; and so on. But of course it is quite im- 
portant that, when measuring liquids, we should use measures having 
the same capacity, else the way would be open for unlimited error 
and controversy. How is this brought about? How do we insure 
that the gallon shall always signify the same thing? Simply by 
requiring that a true gallon measure shall be able to hold a certain 
amount, by weight, of some one substance, no more and no less. 
The standard chosen is pure water under prescribed conditions of 
temperature and air pressure. The amount is 8.33 pounds. This 
fact we express by saying that 8.33 pounds of pure water is the 
standard of liquid measure in the United States. If any receptacle 
proves upon examination to hold more or less than this standard 
amount, it is not a true gallon, and to make it so one must measure 
it something less than full, or full and something over. Only by 
being equal to the standard gallon can it hope to pass as a true 
gallon container. 

The monetary system is in this respect the same as that of liquid 
measure. The money unit is one dollar. But we have many different 
kinds of money in which a dollar may be represented, gold coin, 
silver coin, greenbacks, bank notes, and so on. Now, all these forms 
of the dollar have very different degrees of intrinsic value ; the gold 
dollar is worth just as much whether it is coined or melted into a 
shapeless lump; the silver piece is worth as much as gold when 
coined, but very much less when melted ; the paper in itself is worth 
practically nothing. This being true, it would be very easy for the 
dollar as represented in different kinds of money to have different 
values, — the meaning of the dollar might change with every change 
in the kind of money used, and any accurate reckoning or dependable 
business agreements would become impossible. But here, as in the 
case of liquid measure, uniformity is secured by means of a standard. 
Within the boundaries of the United States, in every conceivable 
connection unless otherwise specified, one dollar means the amount 
of value which attaches to 25.8 grains of gold, nine-tenths fine. 
This amount of gold is known as the monetary standard, and accord- 
ing to it every dollar of actual money is judged. A true dollar must 



l66 PRINCIPLES OF ECONOMICS [XII 

contain the same value as a piece of gold nine-tenths fine, weighing 
2^.8 grains. And if any so-called dollar happens at any time to con- 
tain more or less than this standard amount of value, it is not a true 
dollar, and to make it so, something must be taken away or something 
added. 

Illustrative Problem 

From a conversation in a barber shop in the fall of 1919. "One thing 
I can't understand. The price of almost everything is climbing; but the 
price of gold stays just the same, — always $20.67 P^^^ ounce of pure gold." 
Why is this bound to be true as long as our money laws are unchanged ? 

The Different Kinds of Money. — We have explained the 
denomination system and the standard essential to any monetary 
system. We must now distinguish the different kinds of money in 
which the denominations anc the standard are embodied and comment 
on their several functions. 

The Standard Money. — First, we have the standard money, 
that particular kind of money which immediately embodies or repre- 
sents the r.ionetary standard. As already noted, the standard in the 
United States is 25.8 grains of the metal gold, nine-tenths fine. But 
we do not, of course, actually make any use in ordinary commercial 
relations of the mere metal gold, unmanufactured, in the form of 
dust or lumps. Neither do we have such a lump of gold locked up 
at Washington to act as a standard for our money unit, as we have 
a platinum-iridium bar locked up in that city to act as a standard 
for units of length. The plan we actually adopt is to issue one par- 
ticular kind of money called standard money, which is kept equal 
in value to the real standard, and, j'ust as far as possible, to keep the 
meaning, or value of the dollar in every other kind of money (as 
well as in all credit documents, prices, etc.) the same as the value of 
this standard money dollar. In the American system, the standard 
money is a coin made of the standard substance, gold, and containing 
just the amount of that standard substance which constitutes the 
standard. By devices which will more naturally be explained in a 
later connection, this kind of coin is all the time kept equai in value 
to the quantity of gold bullion which it is presumed to contain ; so 



XII] MONEY EXCHANGE 167 

that it may be said to embody the real standard supposed to He be- 
hind it. 

The Immediate and the Ultimate Standard. — If, as just ob- 
served, the value of the dollar in other kinds of money, in credit docu- 
ments, prices, etc., is kept equal to the value of the standard dollar, 
this does not mean that the dollar in these other relations is directly 
kept equal to the value of a lump of gold weighing 25.8 grains. It 
is kept equal to the value of the standard money, gold coin ; and the 
latter, in its turn, is kept equal in value to the lump of gold. If by 
any process the gold coin and the lump of gold should be separated 
in value, the dollar in other moneys, in prices, etc., would follow the 
gold coin rather than the bullion. This compels us to notice the dis- 
tinction between the immediate monetary standard, the standard 
money, and the standard behind that, which is here called the ultimate 
standard, that is, the lump of gold which, under normal conditions, 
is the real determinant of the value of the dollar. 

In the American system, as just indicated, the standard money, 
being made of the same metal and the same amount of metal as that 
contained in the ultimate standard, may be said to embody the ulti- 
mate standard. This is also the plan followed in most good monetary 
systems. It should be noted, however, that such an arrangement is 
not absolutely necessary ; and we may better understand the relation 
between standard money and the ultimate standard by observing a 
quite different way in which substantially the same end could be 
accomplished. It is perfectly possible, theoretically, to have a system 
in which standard money is made of some other substance than the 
one which holds the place of ultimate standard. Thus, we might cut 
out gold coin altogether, issuing paper as our standard money, and 
yet retain gold as our ultimate standard, provided a dollar in paper 
was all the time kept equal in value to 25.8 grains of gold, while the 
dollar in all other forms was kept equal to that particular kind of 
paper money. 

The plan of having a standard money which does not embody 
the ultimate standard, but is kept at par by some special device, sug- 
gests various schemes, which have been favored from time to time, 
for improving the ultimate standard. Thus, some economists believe 



l68 PRINCIPLES OF ECONOMICS [XII 

that, instead of having a single substance as the standard, we ought 
to use a large number, say loo or more, in order to avoid too great 
and rapid changes in the value of the standard. A natural way to 
work out such a plan would be to issue paper money as the standard 
money, and set up devices for keeping this paper money equal in 
value to the list of goods chosen. Another way would be to have 
for our standard money a coined money, as at present, but to redeem 
that money in varying amounts of gold, always larger than the 
amount in it, and always so adjusted as to keep the value of the coin 
equal to that of the list of goods originally chosen as the standard. 

Illustrative Problem 

Suppose that Congress should pass a law making the money standard 
one one-hundredth part of the value of a certain bill of goods. 

(a) When the scheme was working as intended, what would be the 
total money value of said bill of goods? 

(b) If at a certain time the bill of goods proved to be worth $107, 
showing that the money unit had left the legal standard, which way would 
that unit have gone, up or down? 

(c) Answer the same question, supposing the money value of said 
bill of goods to be $95. 

Functions of Standard Money. — Leaving this study of the 
nature of standard money, we must now add a word with respect 
to its functions. The standard money of our system, gold coin, 
though to a limited extent used as a medium of exchange in ordinary 
trade, is chiefly confined to two offices: (i) serving as the money 
of international trade, and (2) maintaining the gold standard by 
maintaining the convertibility of other forms of money. Standard 
money serves best as the money of international trade because it has 
a bullion or substance value as great as its nominal value, whereas 
other moneys do not. A man who accepts it, therefore, need have 
no misgivings lest he get less than he bargained for. To a limited 
extent international creditors accept non-standard moneys and, as 
we shall see in the next chapter, mere credit. But, in general, 
they must be paid in cash ; and that cash must be something which is 
worth its face value. Hence they demand standard coin, or, even 



XII] MONEY EXCHANGE 169 

better, bullion or bar gold which has not been manufactured into 
money at all. 

But, while gold or standard money is needed for international 
trade, in the domestic exchange of most countries it is very little 
used. The chief function of gold money within a country is to 
maintain the convertibility into gold of other kinds of money and so 
to maintain the standard of the system. The standard, we know, has 
as its function the determining of the meaning or value of the mone- 
tary unit in all kinds of money. But most kinds of money, other 
than gold, for example, silver coin, copper coin, bank notes, etc., 
have in themselves as substance much less value than they claim on 
their face. A silver dollar, as silver, was, until quite recently, worth 
less than fifty cents ; a hundred copper cents are rarely worth more 
than fifteen cents; a paper dollar, as substance, has no appreciable 
value. It naturally follows that some effort is needed to keep these 
different forms of money at par with, or equal in value to, standard 
money. There are various ways of accomplishing this result, but 
none really certain except one which makes it possible to get gold 
money in exchange for any other kind. It is not necessary that we 
be able to exchange other moneys for gold in any and every case, 
but it is necessary that we be able to obtain gold when we really 
need it, — for example, to make payments in other countries, — and that 
without being obliged to pay a premium or suffer inconvenience or 
delay. If at any time when we greatly needed gold we could 
not obtain a dollar of it for a dollar of other moneys, those other 
moneys would inevitably cease to be equal in value to the standard 
money. 

In concluding this treatment of standard money, a word should 
be added concerning a form of paper money which is virtually equiv- 
alent to gold coin. I mean the gold certificate. This is a document 
certifying that the quantity of gold mentioned on its face has been 
deposited in the Federal treasury, and is held ready to be delivered 
in exchange for the certificate. The certificate is thus nothing more 
than a warehouse receipt for the gold coin in deposit. As long as 
the owner only wishes to hold this coin as a reserve or to use it in 
settlements at the clearing house, the certificate is all he needs, and is 
safer and easier to keep and carry about ; and should it happen that 



170 PRINCIPLES OF ECONOMICS [XII 

he really must have the gold itself, he can always get it by presenting 
the certificate. 

Quasi-Standard Money. — We have explained the nature and 
functions of a standard money, basic money, as it is sometimes called. 
We must now comment briefly on the other kinds generally present 
in the systems of our time. First, it is not uncommon to have a 
quasi-standard money consisting of a note issued by the government 
or some special institution, a note which is legal tender in most or 
all relations, and redeemable in standard money. Such a money 
will perform most of the functions of standard money. Being di- 
rectly redeemable in gold, every one will receive it readily, and only 
those who for some reason require the metal itself will insist on 
using the treasury note to get gold. Moneys of this sort, though not 
seldom employed in everyday circulation, have as a more distinctive 
characteristic the fact that they in large measure constitute the bank 
reserves of the country, particularly the central reserves. Doubtless, 
these reserves ought to contain a considerable quantity of gold itself ; 
but the treasury notes answer almost equally well so long as the 
treasury keeps ample gold reserves to redeem them. 

Other Moneys. — The remaining moneys to be found in any 
system with which we are familiar are employed mostly as ordinary 
media of exchange. First come the notes of the national banks pay- 
able at the issuing bank and also at the Federal treasury, having the 
status of legal tender to all national banks, and being receivable for 
all public dues except import duties. Next come the Federal Re- 
serve bank notes. These are akin to the bank notes just named, being 
issued by the Federal Reserve banks on the security of certain types 
of national indebtedness. They were a compromise element in the 
law which established the Federal Reserve system, and would prob- 
ably have been of little moment but for special exigencies growing 
out of the late war. As a matter of fact, a large quantity of them 
was issued ; but the present law calls for their later retirement. 

A third type of ordinary circulating medium is the Federal Re- 
serve note (not bank note), issued by the Regional Reserve banks 
under the authority of the Federal Reserve Board. In form they 



XII] MONEY EXCHANGE 171 

are treasury notes, that is, they are promises to pay, signed by the 
Treasurer of the United States. But the regional banks are re- 
quired to assume the responsibiHty for them as if their own officers 
had made the signature. These notes are a full legal tender. It was 
hoped that they would in time replace all other notes, and even silver 
certificates ; but the prospect for this result is not good. 

A fourth sort of paper money is the silver certificate, which, in 
form, is a warehouse receipt for a corresponding amount of silver 
dollars, but which, in practice, is a bill used for what has been called 
"large change." Until recently, the silver certificate constituted the 
major part of our everyday medium of exchange; but it has been 
latterly replaced by other forms of paper, especially Federal Reserve 
bank notes. Unless, however, some change is made in laws at present 
in force, the earlier condition of things is likely to be repeated. The 
silver certificate is exchangeable only for silver dollars, but it is 
worth its face value in gold jlist as if it were redeemable in that 
metal. 

Subsidiary Coin. — In addition to the moneys already enumer- 
ated, we have various sorts of coin. In general, they are literally or 
virtually subsidiary coins, though, in strict usage, this designation 
is limited to fractional silver. We therefore begin with explaining 
the distinctive characteristics of subsidiary coins. First, these coins 
ai"e put out in small denominations, being specially intended for 
serving as a medium of exchange in minor transactions and as tools 
for "making change." Again, they are made of inferior metal 
metal having low specific value; for a coin of small denomination, if 
made of valuable metal, would be too small for convenience in 
handling. Subsidiary coins are characterized also by shortness in 
weight: they contain a smaller amount of metal than would seem to 
be called for by their nominal value. As a result, they are worth 
less as mere pieces of metal than as money ; so that, unless the value 
of the metal changes greatly, no one will melt them for the sake of 
the metal they contain. Their circulation is thus assured. 

Again, subsidiary coins are strictly limited in the amount coined. 
They are issued only by the government, and the issue is limited to 
the amount which experience shows is really needed for the purpose 



172 



PRINCIPLES OF ECONOMICS [XII 



of trade. This policy is primarily intended to insure the coins of this 
sort against falling in value below their nominal value; and it has 
practically always been successful. So long as the needs of business 
keep subsidiary coins employed, so that few, if any, persons find 
themselves loaded up with an excessive stock, the coins remain at 
par. In the United States, this result is still more fully assured by 
a provision that the United States treasury shall redeem such coins 
at par in legal money. 

Still another characteristic of subsidiary coin is the limitation of 
its legal tender prerogatives. This provision has two objects. First, 
it is intended to hinder any person from burdening creditors to 
whom he is making payment with a great quantity of inconveniently 
heavy coins. Second, it is intended to hinder subsidiary coins from 
displacing the standing money already established and putting them- 
selves in its place, — a thing which might happen, if these coins were 
to become less valuable than standard money while still a full legal 
tender. How this would be brought about will be better understood 
when we have studied the principles governing the monetary standard 
given in Chapter XXXII. 

A final characteristic of subsidiary money, not universal, but 
present under our system, is redeemability. One purpose of this pro- 
vision — to insure that the money shall be kept at par — ^has already 
been explained, and needs no further comment. Another object is 
to enable persons coming into possession of considerable quantities 
of this kind of money to exchange it for more convenient kinds. 
The desirableness of such an opportunity is evident. Business con- 
cerns need enough small coin, but to be loaded up with thousands of 
dollars of such money, when the public generally would object to 
accepting it, would be very undesirable. The provision that the gov- 
ernment shall redeem all such coin meets this difficulty completely. 

The last few paragraphs have dealt with the sort of coin which is 
universally recognized as "subsidiary." A word or two should now 
be devoted to the varieties not always, or perhaps usually, counted 
in this class. First, we have token money or billon, consisting of 
very small coins made of cheap metals, for example, our nickel five- 
cent pieces and copper cents. This type of money was evolved 
earlier than the coins usually designated as subsidiary. But, theo- 



XII] MONEY EXCHANGE 173 

retically, there is no good ground for distinguishing them from the 
latter; they usually have all the characteristics above enumerated 
for subsidiary coins proper. 

The other money which is virtually, though not literally, a sub- 
sidiary coin is the silver dollar already alluded to on page 172, 
This cannot be strictly described as a subsidiary coin, because it 
lacks the characteristic of limited legal tender which is present in true 
subsidiary coins everywhere, and also lacks the redeemability of 
American subsidiary coins. Furthermore, while the silver dollar is 
not a full weight coin, it does not possess the characteristic of short- 
ness of weight in so great a degree as the real subsidiary coins. Thus 
two half-dollars or four quarters do not contain quite as much metal 
as does one silver dollar. In effect, however, it is a subsidiary coin. 
It has most of the characteristics, and behaves as if it had them all. 
Although not limited, as are true subsidiary coins, in legal tender 
prerogatives, it does not displace the standard. And although not 
redeemable, it remains at par in spite of the fact that its metal value 
is much below its face value. These facts, however, should not lead 
us to think that the silver-dollar situation is an entirely satisfactory 
one. On the contrary, most specialists are convinced that the silver 
dollar ought either to be withdrawn altogether, or frankly and com- 
pletely given the status of subsidiary coins. 

Illustrative Problems 

1. Illustrate with concrete examples the drawbacks of barter as a 
method of exchange. 

2. Illustrate the use of money as a measure of value in a case of 
barter. 

3. In primitive communities the media of exchange have usually been 
objects desired for direct use and also objects commonly produced in the 
community. Give some reason or reasons for each of these facts. 

4. During the first part of our history as a nation, silver fractional 
coins had the prerogatives of standard money, i. e., were freely coined 
and had the status of full legal tender. But in 1853 Congress deemed 
it necessary to put this kind of money into the position of subsidiary 
coin. How do you explain the fact that Congress got around to this 
opinion at about that particular time? 



174 PRINCIPLES OF ECONOMICS [XII 

5. Between 1890 and 1896 it was a common practice to put into notes 
and mortgages a clause providing for payment in gold coin of legal 
weight and fineness. Try to get the proper explanation of this fact. 

6. When I say that 12.9 grains of gold .9 fine is the monetary stand- 
ard of the Philippines, what is meant? 

7. In the United States in the year 1868, when gold payments on 
treasury notes were suspended so that a gold dollar was commonly worth 
from $1.20 to $1.40, one of the great political parties proposed to pay 
the national debt in these irredeemable treasury notes, — which proposal, 
however, was defeated in the Federal election of that year. In discuss- 
ing the matter, writers commonly speak as if the national creditors ob- 
jected to being paid in treasury notes rather than gold; whereas no one 
of them probably would have thought of asking for literal gold money. 
Explain in scientific language what was the precise issue of the contro- 
versy. 



CHAPTER XIII 

CREDIT EXCHANGE 

I 

The Process of Credit Exchange 

We showed in the last chapter why exchange was not and could 
not to any great extent be conducted on the barter plan, and why a 
mechanism of exchange had been built up, consisting of specialized 
processes and instruments or media. We have thus far discussed 
one of the processes — money exchange — and one set of instruments, 
— money. We now pass to a second process called Credit Exchange, 
and the set of instruments employed by it, called Credit. 

Deficiencies of Money. — Money exchange, as we saw, is 
superior to barter chiefly because of the fact that it uses a single 
standardized medium which everyone is willing to accept. But it is 
easily possible to overstate the convenience and facility of trade re- 
sulting from the use of this device. Everyone is willing to accept 
money, we say ; but as a matter of fact, if a man sells a thousand or 
ten thousand dollars' worth of wheat or meat or land, he usually is 
very far from willing to accept actual money in exchange. In former 
ages, when actual possession of the money metal was prized as a 
sign of distinction, possibly most individuals received without hesita- 
tion practically all the money they could get. But this is not so 
today. No man however fond of wealth desires to have a bushel of 
money dumped on his floor. The heap would add little to his dis- 
tinction, and would greatly embarrass him. 

But the use of money may be inconvenient for other reasons 
also. It is unlikely that any would-be purchaser will have a bushel 
of money to give. Because of the difficulty of guarding it, and be- 
cause of its entire uselessness when not in active circulation, even 

175 



176 PRINCIPLES OF ECONOMICS [XIII 

the richest men prefer to keep in their possession at any one time only 
a small quantity sufficient to supply their everyday wants. When 
one requires a large lump sum, then, how shall he obtain it? Wait 
till it gradually accumulates, hoarding it as it comes in ; scurry here 
and there, selling a little something to this man and a little something 
to that till he gets together a sum sufficient for his purchase ? Fur- 
thermore, if he buys at a distance, at the extreme end of the continent 
or beyond an ocean, must the purchaser undertake the toil and ex- 
pense and danger of transporting the money and delivering it into 
the seller's hands? By no means. These difficulties are obviated 
by the use of a still more highly developed medium of exchange, 
called Credit. 

Credit Exchange Defined. — Briefly stated, credit exchange 
is the exchanging of goods for goods through the medium, not of 
money, but of a right to claim money. This is implied in the name 
"credit exchange." But this account of the matter is too compressed 
to be adequate. To serve as a medium of exchange is to be some- 
thing which enables us to trade goods belonging to us for other goods, 
more easily and conveniently than we could by direct barter : we 
trade our goods for that medium, and then trade that medium for the 
other goods. Unless both of these operations are performed, the 
thing in question is not serving as a medium of exchange. It is not 
such a medium if we merely get it in exchange for our goods, and 
stop there. If we use the right to money — credit — in this way, we 
have merely loaned to our customer the money equivalent of the 
goods. All in good time he will have to pay the debt with money, 
which money will be the real exchange medium of the transaction. 
In like manner, credit is not a medium of exchange when I merely 
give it in exchange for other people's goods. In that case, they have 
lent me the money value of those goods. All in good time I shall 
have to pay them money which will, therefore, have been the real 
medium of exchange for the transaction. Credit itself will be the 
real medium provided only I use the claim created by selling my 
goods, to buy the goods of the other people. 

Reciprocity of Credits Necessary.— It follows from the last 
paragraph that, if credit is to be used as a substitute for money, it 



XIII] CREDIT EXCHANGE 177 

must be capable of acting as a true medium of exchange, — after I 
have accepted it in exchange for my goods, it must be able to buy the 
goods of other people. But, in order that this should be possible, it 
is necessary that the relation of debit and credit which is inherent 
in the system should be reciprocal. I must sell other people goods 
and other people must sell me goods ; and the words "other people" 
must in some sense refer to the same persons. If certain persons 
wish to buy goods from me, while I, in turn, wish to buy goods from 
them, then I can sell them my goods for credit — ^the right to claim 
money — and then use that credit to buy their goods. In such a 
transaction, credit will have served as a medium of exchange. The 
transaction uses a medium of exchange, since goods are not directly 
traded for goods but for a go-between ; and credit, rather than money, 
is that medium, since the reciprocal claims cancel, and so money is 
not used. 

A situation such as that outlined naturally arises between two 
neighboring dealers who are mutual customers. If Hoaglin, the 
clothier, is likely to sell Frost, the shoe dealer, one hundred fifty 
dollars worth of clothes in the course of the year and to buy from 
Frost one hundred thirty dollars worth of footwear, credit can 
easily serve as the medium, money being used only for the twenty- 
dollar balance. 

The Difficulty. — In the illustration of credit exchange just 
used — book credit it is commonly called — reciprocity of claims was 
inevitably present because but two persons were involved: if two- 
sided trade went on at all, it could not help setting up reciprocal 
claims, which could be used as the medium of exchange. But situa- 
tions of this sort are comparatively rare. We do not usually buy 
from, and sell to, the same individual or set of individuals; we are 
far more likely to buy from one set and sell to another. Thus, the 
farmer sells his corn and oats to the elevator company and buys 
nothing from that company whatever; while he buys clothing, car- 
riages, lumber, and other commodities from a set of merchants to 
whom he sells nothing whatever. Here mutuality of claims is non- 
existent; hence cancellation is out of the question; how then can 
credit be used as a medium of exchange? 



178 PRINCIPLES OF ECONOMICS [XIII 

Solution: A Common Debtor and Creditor. — The solution is 
not so difficult as it appears at first sight. Even in this situation a 
true reciprocity of claims exists, — only it exists between each person 
and all the rest taken together. If the farmer could in some way take 
what he owes everyone and set it over against what everyone owes 
him, a practically complete cancellation would be possible. He may 
not sell anything to any of the particular persons from whom he has 
occasion to make purchases ; but he must sell to some persons, else he 
could not buy. It follows that, if the proper apparatus were avail- 
able, he could use the claims against other people taken as a whole, 
which his sales had created, to buy the goods for which he wished to 
exchange his own. That is, credit would here again act as a go- 
between, a medium of exchange. The carrying out of such a 
scheme plainly involves what we call a pooling of the claims for and 
against the persons other than the one we are considering, growing 
out of transactions with that one person. No plan has ever been 
adopted whereby such a system could be applied to all transactions. 
But a device early developed extends its use to the major part of 
wholesale transactions and in the United States to more than half 
the retail transactions. That device may be described as, in general, 
one which makes one institution or group of institutions, a sort of 
common debtor and creditor, and allows it to effect settlement w^ith 
each of its patrons, as itself the representative of all the rest. 

Banks Fill This Position. — The institution which commonly 
serves different individuals in this capacity is the so-called commercial 
bank or the commercial department in some other type of bank. The 
primary functions of such an institution are, in ordinary banking 
language, deposit and discount — ^to care for the current funds of its 
patrons and make short advances to them as the need may arise. 
But an institution which takes care of its patrons' current funds al- 
most inevitably is called on to make payments for them — at least 
this is the case in most English speaking countries ; and in doing that 
it naturally drifts into the position of common debtor and creditor. 
When Mr. A, one of the bank's depositors, orders the bank by check 
to pay $20 to another depositor, Mr. B, and Mr. B deposits the 
proceeds of the check in the same bank, this act makes Mr. A the 



XIII] CREDIT EXCHANGE 179 

debtor of the bank for $20 and makes Mr. B the creditor of the bank 
for the same amount. When, now, some other depositor orders the 
bank to pay $18 for him to Mr. A, the latter becomes a creditor of 
the bank for this $18, which is entered on his account, cancelhng all 
but $2 of the debt created by A's $20 check in favor of B. So, 
when B gives still another depositor of the bank a check for, say, 
$25, he thereby becomes the debtor of the bank, the pooling agent, 
for $25, which is cancelled by book entries against his former credit 
of $20, leaving a debit balance of $5.^ 

Thus the process goes on indefinitely. Every check drawn by A 
makes him a debtor of the bank for the amount named, and every 
check drawn by another depositor in A's favor makes him the 
creditor of the bank for that amount ; and the same is true of B or C, 
or any one of the whole list of depositors. In short, we see per- 
fectly fulfilled the conditions mentioned as necessary for the working 
of credit exchange. Reciprocity is established between debts or 
claims ; A's debts to other people are set over against other people's 
debts to him. And, given this reciprocity, cancellation becomes pos- 
sible, and so credit exchange — exchange without the use of money 
— becomes possible. 

In the preceding illustration we have supposed that Mr. A and his 
neighbors all keep deposits in the same bank. But generally there 
are several banks in one community ; some are used by a part of the 
population and some by another part ; and Mr. A, whose transactions 
we may suppose are many and various, will have debits and credits 
to settle with the patrons of banks other than his own. At first sight, 
this seems to result in a return to cash exchange, since a check on 
one bank deposited with another will not be debited to the former 
bank for any length of time, but will be promptly presented for 
cash. In fact, however, the bank which is debtor because of the 
supposed transaction will doubtless have come into possession of 
checks on the creditor bank which it can use to offset the claim 
against itself. Even if it has at the time no claims against that 



* It should be remembered that each depositor is expected to keep some 
balance with the bank, a practice which insures that the bank can safely 
assume the position of debtor on behalf of the man who writes a check 
in favor of another depositor. 



l8o PRINCIPLES OF ECONOMICS [XIII 

particular bank, it will certainly have some against other banks in 
the community ; and, since all the banks will settle their mutual obli- 
gations on a pooling plan, these claims against other banks will do 
just as well in offsetting its debits as claims against its actual 
creditor. 

The Bank Clearing. — We thus come to another very im- 
portant development of credit-exchange, the clearing, or settlement 
of mutual obligations among a number of different banks. Here 
the same device which enables Mr. A to adjust his debits and credits 
with a minimum use of actual money, is applied to settle the mutual 
obligations of banks. In general, the plan is to set up a common 
agent, a clearing-house association, which becomes the creditor of 
each bank for claims of all other banks against it, and becomes its 
debtor for claims against all other banks. At regular intervals a 
balance is struck and the one which proves to be debtor, the bank 
or the clearing-house, pays the balance. Naturally, the clearing- 
house settles first with the banks which prove to be debtors, and 
then uses the money thus obtained to pay the creditor banks. 

Inter-Local Exchange. — Our discussion has thus far had to 
do with exchange carried on through banks between persons in the 
same community. Another and much older form is inter-local 
credit-exchange, or what we call Exchange in the pre-eminent sense. 
This form is resorted to for making payment between different cities 
and countries with a minimum use of money. Here we have again 
the same familiar device : claims for and against different countries, 
debits and credits, get into common hands so that reciprocity is es- 
tablished and cancellation is made possible. Certain institutions in 
each country, banks or exchange houses, buy up all the claims on the 
other countries and also sell for the use of their patrons claims on 
those other countries. Thus, they become the common creditors 
and the common debtors of the dealers of their country in its rela- 
tions to others ; and the debit and credit relations which they main- 
tain with other countries are maintained with institutions similar to 
themselves. It therefore becomes easy to set the debits of a country 
over against its credits, cancel these in so far as they are equal, and 



XIII] CREDIT EXCHANGE i8l 

effect a complete settlement by paying or receiving a small balance 
in money. 

II 

Instruments of Credit Exchange 

As coins and bills of various different kinds constitute the in- 
struments or media used in money exchange, so a variety of paper 
documents constitute those used in credit exchange. Some of these 
take the form of a direct promise between man and man to deliver 
a specified amount of money at a specified time. But, inasmuch as 
the promise must ordinarily be made good through the agency of a 
third party or institution, most of these documents are really orders 
made by one person, called the drawer, in favor of another person, 
called the payee, upon a third person or institution, called the drawee. 
If the payee does not himself find it convenient to present the docu- 
ment to the drawee for cash or for cancellation against his own 
promises to the drawer, he can transfer it to another person by in- 
dorsement — writing his own name across the back, with or without 
some specific directions as to payment. 

The most familiar credit instrument is the bank check which has 
already been mentioned. It is an order for the payment of money 
drawn by a man upon the bank where his own money is kept in 
deposit. It is used principally within a single town or limited com- 
munity where the drawee bank is located, and where both drawer 
and payee are known. Inter-local exchange makes very considerable 
use of the check, though banks much prefer other instruments spe- 
cially adapted to this purpose. Most important of these is the 
bank draft, an order for the payment of money drawn by one bank 
on a bank in another place, in favor of another party. A bank draft 
is employed when the initiative in settling a debt is taken by the 
debtor. He buys the draft, and mails it to his creditor ; the creditor 
then gets cash or credit for it from his bank ; and the bank, if not 
itself the drawee named in the draft, proceeds to collect from the 
bank which is. Another class of exchange instruments similar to 
the bank draft are so-called money orders, — postal or express orders. 
These are drawn by local agents of the institution issuing them upon 
the central office, are sold to the debtor, and sent by him to the 



l82 PRINCIPLES OF ECONOMICS [XIII 

creditor, who collects from the agent of the issuing- institution located 
in his own. town. When the initiative in settling a transaction is 
taken by the seller or creditor, the instrument employed is named a bill 
of exchange, though this phrase is also often applied to international 
bank drafts. Such a bill of exchange, also called a commercial draft, 
is an order for the payment of money drawn by a seller or creditor 
upon his debtor in favor of the drawer or his banker, (If in favor 
of himself, he indorses it over to his banker.) The creditor turns the 
draft over to his banker and gets credit for the amount named, where- 
upon the banker sets out to collect from the drawee through bank- 
ing correspondents. 

Ill 

The Rate of Exchange 

Definition. — A matter of much importance in connection with 
credit exchange is the rate of exchange, particularly the rate in for- 
eign exchange. As we have just learned, money payments between 
the people of different communities are effected through agents who 
assume the position of common creditor and common debtor for 
each community. An agent in one community buys up money claims 
on other communities from persons having such claims to dispose of ; 
and he sells money claims on other communities to persons needing 
them to make payments in those other communities. Thus, there is 
developed a traflfic in such claims, a traffic in "exchange," as it is 
called ; and the price at which exchange sells — at least exchange be- 
tween different countries — is called the rate of exchange. Stated 
more formally : the rate of exchange is the price in one country paid 
in the money of that country for the right to dispose of a unit of the 
money of some other country in that other country, or at least in 
some country other than the one in which the purchase is made. 
Thus, if I wish to buy from my bank the right to have five pounds 
sterling paid on my behalf in London, and find myself obliged to pay 
for that right $4.87 per pound, I say that the rate of exchange on 
-London is $4.87. 

In domestic exchange, — exchange between different parts of the 
same country, — the rate of exchange usually means the difference 
between the face value of an instrument of exchange and what is 



XIII] CREDIT EXCHANGE 183 

paid for it. Thus, if I say that the Chicago rate of exchange on 
New York is 15 cents premium per thousand, I mean that, in selling 
a claim for $1,000 on New York, a Chicago dealer would get his 
$1,000 and fifteen cents additional. 

The Par of Exchange. — In working out the price or rate of 
exchange, the market starts with the natural value of the unit of 
the money wanted, as measured in the money with which it is bought 
— that is, the value as it would be if there were no difference of 
place, if the buyer of English money bought it right in New York to 
be delivered in New York. If the two countries have the same 
standard, then the natural value of either money in terms of the 
other can be ascertained by a simple operation in division. Thus, 
one dollar contains 23.22 grains of fine gold ; and the English pound, 
113 grains. The pound, therefore, is naturally worth in our money 
as many dollars as 23.22 is contained in 113, or $4,866. This natural 
price of a foreign money unit, measured in terms of the home money, 
is technically known as the par of exchange. 

Variations in the Rate of Exchange. — The rate of exchange 
varies above or below the par of exchange according as the demand 
for exchange at par is in excess of the supply or vice versa. If the 
United States is selling great quantities of cotton and wheat to the 
people of Europe and buying comparatively little from them, then 
claims on Europe will be abundant and, other things being equal, 
cheap; those Americans who have claims on Europe to sell will be 
obliged to sell them cheap, while those who need such claims can buy 
them cheap. On the other hand, if the United States is buying many 
goods from the people of Europe and selling them comparatively 
few, then claims on Europe will be scarce and, other things being 
equal, dear; those Americans having claims on Europe to sell can 
obtain high prices, while those needing to buy such claims will be 
obliged to pay high prices. 

Limits: Gold Points. — These variations of the rate of ex- 
change above and below par are limited by the cost to exchange houses 
of transporting the money itself from the one place to the other, — 



l84 PRINCIPLES OF ECONOMICS [XIII 

it being understood that cost includes a reasonable profit to the ex- 
change dealer. Any wider variations would give exceptional profit 
to the exchange dealers, which would stimulate their competition, 
and so reduce the difference to this amount. In London exchange, 
the possible variation from par is commonly in the neighborhood 
of three cents ; in other words, the rate ranges from about $4,835 to 
$4,895. These are called the gold points because, outside these 
points, sending gold would be cheaper than using exchange. 

Illustrative Problems 

1. Suppose that you send a check on the National Bank of Ann 
Arbor to the Newcomb-Endicott Company of Detroit to pay for some 
goods purchased; and suppose that when the check finally gets back 
to you it shows the following indorsements : ( i ) Pay to the Peninsular 
Savings Bank of Detroit, the Newcomb-Endicott Company. (2) Pay 
to the State Savings Bank of Ann Arbor, Peninsular Savings Bank of 
Detroit. (3) Paid through the Clearing House, State Savings Bank 
of Ann Arbor. Trace the course of this check from the indorsements. 

2. Henry T. Crouch of Erie buys $1,275 worth of wheat from T. C. 
Craig of Detroit. 

(a) Suppose settlement to be effected with a wheat bill of exchange 
(also called a sight draft) and write out the substance of the bill which 
would be used. 

(b) Suppose settlement to be made with a check and write out a 
facsimile (in substance). 

(c) Suppose settlement to be made with bank draft and write out a 
facsimile (in substance). 

3. Whichever method of settling the transaction involved in the last 
problem is used, the particular credit document employed will inevitably 
take quite a journey from bank to bank while it is being collected. 

(a) Describe an imaginary course, which it would very likely take 
if it were a sight bill of exchange. 

(b) Same, if it were a check. 

(c) Same, if it were a bank draft. (Compare Problem i.) 

4. We buy a good deal from Brazil, but sell her little. We sell a 
great deal to Great Britain, but buy from her much less. Can you im- 
agine a way in which one of these trades furnishes a medium of ex- 
change for the other? 



XIII] CREDIT EXCHANGE 185 

5. Oct. I, 1907, the different banks of Ann Arbor brought to the 
clearing claims against each of the other banks as follows : 

No. I againsi No. 2 against No. 3 against 



No. 2 $2213.19 No. I $428478 No. I $4974.66 

No. 3 1865.09 No. 3 2172.45 No. 2 1607.79 

No. 4 2415.96 No. 4 3043-18 No. 4 1093.24 

No. 5 512.21 No, 5 655.87 No. s 625.88 



Total $7006.45 Total $10156.28 Total $8301.57 
No. 4 against No. 5 against 



No. I $3078.73 No. I $ 332.15 

No. 2 1793.16 No. 2 2,77.17 

No. 3 97373 No. 3 15 1546 

No. 5 4633-96 No. 4 181.56 



Total $10479.58 Total $2406.34 

Compute the balance for or against each bank. 

6. Supposing all the claims of the Ann Arbor banks on one another 
which appear in the last problem to have consisted of checks which 
were used in the usual course of business transactions. 

(a) What must have been the total volume, expressed in money, of 
the transactions thus effected? 

(b) How much actual cash was needed to effect these transactions? 

(c) What per cent of the total volume of transactions did this cash 
amount to? 

(d) What is the significance of these facts? 

7. Not many years ago it was estimated that the per capita money 
circulation of England was about $11 while that of France was about $51 ; 
yet, as every one knows, there was at least as much business per capita 
carried on in England as in France. How could the difference in the 
amounts of circulating medium required be explained? 

8. Some writers represent the development of credit-exchange as a 
return to barter. Show that this is not true — that credit-exchange is 
still mediated exchange, nay more, that it is money exchange. 

9. Suppose I wish to buy a bank draft for £200 on London. With 
London exchange at $4,855, what should I be able to get the draft for? 

10. A wheat exporter of New York draws a bill on his London 
customer for £1375. What should he be able to get for this bill with 
London exchange selling at $4.87 ? with London exchange at $4.84 ? 



l86 PRINCIPLES OF ECONOMICS [XIII 

11. Suppose that a New York importer can get 50 gross of Sheffield 
razors dehvered in New York for 44 pence each (the duty included), and 
that he can sell them for 95 cents each. What would be his profit on 
such a transaction if the rate of exchange on London were $4.84? if the 
rate were $4.87? 

12. From the last two problems what principles can you deduce as 
to the effect which a high or low rate of exchange tends to have on 
exports? On imports? 

13. "The greater part of our circulating medium consists, not of 
money, but of deposit currency." Explain what is meant by deposit 
currency. 

14. Near what point would you expect the rate of exchange on 
Europe to be found in the fall of the year? Why? 

15. "A matter very frequently overlooked by the public is that a 
large share of the bank deposits of a country like the United States 
grow out of loans and so do not add to the cash holdings of the banks." 
Explain how this is so. 



CHAPTER XIV 

SOME MONEY TRUISMS 

Having briefly analyzed and described the system of Money and 
Credit Exchange, it is now in order to set forth some of the prin- 
ciples governing that system. It is much too early in our study to 
attempt anything resembling a thorough exposition of the theory of 
money. Nevertheless a few of the simpler principles which, though 
little more than truisms, are frequently overlooked by the public 
with the result that foolish errors gain acceptance and lead to hurtful 
legislation, should receive attention at the very outset. 

Money Small Part of Total Wealth. — The first point requiring 
emphasis has to do with the common fallacy which regards, or seems 
to regard, money as the only kind of wealth. In earlier centuries, 
whole communities have entertained such an idea, and even in our 
own day many people stand dangerously close to the same position. 
Anything that reduces the monetary stock of a community tends, in 
their opinion, to make that country poorer, no matter what the 
reducing force may be ; and anything that increases the monetary 
stock, whether a balance of trade causing the import of money from 
other countries, or coinage by the government within the country, 
must have the effect of increasing wealth. 

There is no doubt some little excuse for this attitude of mind in 
the predominant place which money holds in our everyday thought 
and speech concerning wealth. We express wealth, of whatever 
kind, in terms of money, for example, when we say that "Smith has 
inherited a half million of dollars," though as a matter of fact he 
has inherited only land, factories, and stocks valued at a half million 
dollars. It is a fact, too, that money will procure for us any other 
kind of wealth we may desire, and hence itself appears to us the 
most efficient and desirable form of wealth, the wealth par excellence. 

187 



l88 PRINCIPLES OF ECONOMICS [XIV 

Nevertheless these considerations surely do not justify us in con- 
ceiving money to be the only form of wealth. Any kind of goods 
capable of yielding satisfactions and having exchange value — dia- 
monds, bullion, land, or what not — are wealth just as truly as coined 
money. It is essential therefore to keep always in mind the follow- 
ing proposition : 

Money is simply one particular kind among many kinds of 
wealth. 

Money Small Part of Total Capital. — The second fact need- 
ing to be insisted on at this point is that money is not the only kind 
of capital. Considered as an instrument which we employ to facili- 
tate the exchange of goods and to accumulate or transfer stores of 
value, money is of course capital, just as truly as buildings, engines, 
or machinery. But certain peculiarities of money have led careless 
persons into thinking and talking about it as if it were the only true 
capital. Thus all forms of capital, like all forms of wealth in gen- 
eral, are computed and expressed in terms of money, as when we 
say, "Mr. Craig has $200,000 of capital in the milling business." 
We seem to mean here that $200,000 in money constitutes the capital 
which Mr. Craig devotes to the production of flour ; but what we 
should mean is that Craig owns and devotes to such production cer- 
tain buildings, dams, races, and machinery which have a value 
measured in money of $200,000. He may not, and almost certainly 
does not, possess anything like that amount of money capital, as 
money. 

Again, people are sometimes led to look upon money as the only 
form of capital, from the fact that money constitutes the immediate 
form in which most capital is accumulated. A person desiring to 
accumulate a fund of capital, to invest in the milling business, let us 
say, puts away his savings, in the form of money or credit with his 
bank ; and only after the sum of money or credit has grown large 
does he part with it, obtaining in exchange the capital goods — lumber, 
engines, and machines — necessary to commence production. Still, 
the money stage of capital is obviously only temporary and transi- 
tional ; it lasts only while enough is being stored up to bring in return 
an appreciable amount of capital in another sense. For this money 



XIV] SOME MONEY TRUISMS 189 

is only the representative form of capital, the shadow, not the sub- 
stance. At the same time that the capitalist is accumulating stores 
of money or bank credit, other men are manufacturing, practically, 
if not literally, to his order, lumber, engines, and machines; and 
these other things for which the capitalist, or someone who borrows 
from him, exchanges his store of money or bank credit, constitute 
the real, final, form of capital. The truth embodied in the following 
proposition should, therefore, be constantly borne in mind. 

Money is simply one among many kinds of capital {capital 
goods), i. e., products which are wanted, not for their own sakes, 
but for the sake of other things which we can get through them; 
and relatively, money forms a rather small portion of the total cap- 
ital of the community. 

Only Enough Money Wanted. — Another mistaken notion 
with respect to money, which has caused a great deal of trouble in the 
past and is still very widely held, conceives that a country can never 
have enough money, — can to advantage increase its stock of this 
particular form of capital indefinitely. Every addition is eagerly 
welcomed; every withdrawal is looked on with anxiety. Increasing 
the quantity of money is offered as a panacea for almost every un- 
desirable feature of business. All this is, of course, very hard for 
the student to comment on with patience. The quantity of money 
a country can advantageously supply itself with is wholly a matter 
of the need, the money work to be done, over against the quantity 
of its resources which it can afford to use to satisfy this particular 
need in view of the relation between its total needs and its total 
resources. Doubtless there is no way of ascertaining with precision 
just how much this means. But that it is a limited amount no one 
would deny. The actual work in which the money stock of a 
country is at any moment being employed is serving as reserves be- 
hind the credit of the country, passing from hand to hand in ex- 
change for goods and in payment of obligations, and being held by 
people in reserve for current uses and in the process of accumulating 
capital. For the uses which involve passing from hand to hand, 
any particular pieces of money will be used over and over again, 
so that the total needed for this purpose will be much smaller than the 



igo PRINCIPLES OF ECONOMICS [XIV 

total amount of work to be done would seem to indicate. Further, a 
large share of the money work of this kind needing to be done is 
performed by credit substitutes which are extemporized for each 
transaction ; and their volume has little reference to the quantity of 
money proper in the country. It is thus possible that the country 
should experience great changes in the money work to be done with- 
out any inconvenience resulting, even though the quantity of money 
had not shown a corresponding change. 

But not only is the community's need for money a quite limited 
quantity, it is surely very foolish to want to have more than this. To 
insist on supplying ourselves with a larger amount is like filling up 
one's house with cook stoves or tubs or washing machines. Any time 
or energy which we expend in acquiring such objects beyond the 
needs of the kitchen and laundry lays upon us a burden in caring for 
them, and, worse, it reduces the time and energy which we have to 
use in supplying ourselves with fuel, food, clothing, and other 
needed articles. Putting this point into a formal proposition gives 
us a third principle. 

Money is simply one particular kind of useful instrument of 
which our stock should he large enough to do the money work need- 
ing to he done as well as we can afford to have it done, hut of which 
we do not want an excess any more than we want an excess of 
chairs, clothes, stoves, engines, or any other useful article. 

Money Naturally in Circulation. — A fourth widely accepted 
fallacy connects itself with the supposed advantages of "putting 
money into circulation." Exactly what this phrase means in popular 
usage is often hard to determine. If it means causing money to 
flow, or pass from hand to hand, the phrase is merely an empty one 
without excuse for being. Money is always in circulation, passing 
from one person to another in purchase of goods, or held awaiting 
occasion for such use. It will circulate anyway ; from its very nature 
it is bound to circulate. Or perhaps the phrase means to render 
money more active, cause it to spend a greater part of the time actually 
going through the air, effecting exchanges, instead of lying motionless 
in men's pockets. But to expect that any benefit will result from 
causing money to change hands a greater number of times in an 



XIV] SOME MONEY TRUISMS 191 

hour or in a day is of course absurd. There is nothing beneficial 
in the exchange, per se, of money, because there is nothing beneficial 
in the exchange, per se, of goods. The exchange of goods should 
occur just often enough to enable us to dispose of those we have 
produced and to get possession of other goods which will be of most 
advantage to us as consumers. Any more exchanging would be, 
obviously, a waste of our time and effort. But, since money passes 
from person to person merely as a counter, a check against other 
goods, the number of times it can advantageously change hands is 
limited to the number of times those other goods can advantageously 
change hands. To pass it more frequently — if that were possible — 
would be merely a purposeless waste. 

There is one other possible interpretation for the phrase. By 
"putting money into circulation" some people mean creating a de- 
mand, which would not otherwise exist, for goods and services, thus 
increasing the sales and the incomes of people generally and making 
the whole community more prosperous. This belief is no more 
tenable than the ones just discussed ; but since the particular fallacy 
involved is one in contravention of a principle of trade which we 
designate Say's Law, and which is treated in the next chapter, we 
must reserve the consideration of this fallacy for that connection. 
The chief point of our present discussion may be summarized as 
follows : 

Broadly speaking, it is of the very nature of money to circulate 
(in person or by proxy), that is, to pass from one person to another 
in purchase of goods or to he held azvaiting the occasion for such use. 

Money Naturally Remains Money. — Another truism which 
needs only to be understood to command immediate acceptance, and 
yet is constantly overlooked, has to do with the fact that the stock 
of money is not necessarily any measure of the existing wealth of 
a community. When we complain of the squandering of a great 
capital by a worthless heir, people at once say, 'T don't see that 
any harm is done. The money spent by the foolish heir is still here. 
It has only been transferred to better hands." 

Of course the money is still here. Money is a bit of social ma- 
chinery of a highly durable character, which lasts almost indefinitely, 



192 



PRINCIPLES OF ECONOMICS [XIV 



needing only small additions to keep it intact, like such permanent 
forms of capital as roads, canals, etc. Of course, then, the money is 
still in existence just as if the spendthrift had not thrown it about 
him so freely for yachts, dances, feasts, and other frivolities. But, 
on the other hand, there is a total lack of something else which would 
have come into being if the son had followed in the footsteps of his 
father. The father would have looked upon his money as a tempor- 
ary or transitional form of capital, and would have gone on to 
consummate the process of capital production by the purchase of 
productive goods — engines, cars, bridges, shops. These goods could 
have been produced by the same labor which was expended in min- 
istering to the young man's follies, and they would have continued 
for years to give off services, instead of totally disappearing, like 
the orchestra music or the champagne, over night. As a result of 
the young man's spending, therefore, society as a whole is vastly 
poorer than it might have been, even though the quantity of money 
is not altered in the least. 

Broadly speaking, it is of the very nature of money to remain 
money — not to he consumed in the sense of being finally absorbed 
into the life of any individual. Hence the fact that the stock of 
money is unchanged proves nothing as to how the amount of wealth 
or capital is affected by particular lines of conduct. 

Trade Does Not Drain Off Money. — A final fact deserving 
mention in this place relates to the effect of foreign trade upon the 
stock of money in any community. "Everything we buy abroad," 
so runs a popular fallacy, "takes just so much money out of the 
country," and the conclusion is drawn that the country thereby falls 
into great economic distress. Now a moment's reference to the 
facts set forth in our analysis of the Credit Exchange should make 
clear to anyone the error in this belief. We do not make our pur- 
chases abroad with money, but with instruments of credit. In like 
manner, we sell our goods abroad, not for money, but for instru- 
ments of credit. These two sets of instruments are cancelled against 
each other, only balances going in money; so that the amounts of 
money actually passing from one country to another are very insig- 
nificant. Further, of course, those balances will naturally be in favor 



XIV] SOME MONEY TRUISMS 193 

of any particular country just as much as against it. That is, there 
will very likely be no net movement of money at all. 

There is indeed one condition under which there will tend to be 
a net outward movement of money from a country practically all the 
time. If we are a gold producing country and spend much of our 
strength producing this metal, and little in producing other goods 
which we can export to pay for our imports, then, of course, the 
balance of credit against us will be great, and we will have to export 
much money to cancel it. But even here we are not exporting money 
in any true sense. If we spend much time producing gold, we prob- 
^ably mine, refine, and subsequently coin into money a far greater 
amount than we can advantageously use as money. So far as our 
internal business is concerned, therefore, this excess is hardly to be 
called money; it is merely the metal, gold, a product of our labor, 
like wheat, or shoes, or pork, which we can and should ship abroad 
to those who desire it, in payment for the products which we desire 
of them. 

But, while a country which is a large producer of gold, the money 
metal, may show a large net export of this kind of money, this will 
not be the case with other countries. Those which produce none at 
all will in the long run show a net import of such money; while those 
which produce _fust about enough to meet their own needs will have 
neither a net export nor a net import. Between countries, as within 
countries, money will act just as a medium of exchange must act. 
That is, it will come and go, go and come, — being wanted not to use 
for eating or wearing or warming houses or for any purpose that 
involves retaining possession of it or destroying it, but to use in 
exchanging our products for the products of other countries. 

It is of the very nature of money to go hack and forth between 
communities ; trade with the outside world does not of itself tend to 
take away our money. 

Illustrative Problems 

I. "Foreign trade can add to the national wealth only when it brings 
in a money balance." 

(a) What is the principal thing to be gained by maintainine: trade 
relations with the outside world? 



194 PRINCIPLES OF ECONOMICS [XIV 

(b) When would it be of advantage to have our foreign trade bring 
in a money balance? 

2. "A nation is so much poorer by every dollar it sends out, just as 
an individual is so much poorer by every dollar he spends." Criticize 
both clauses. 

3. "Everything we buy abroad takes just so much money out of 
the country." 

Show that this cannot be true whether it is meant that such buying 
abroad takes the money out immediately or only ultimately. 

4. Suppose that official reports from all the banks of a certain city 
show that, on an average, 93 per cent of the deposits received during a 
certain day consisted of checks, only 7 per cent being in the form of 
money. What important fact with respect to the conduct of business in 
that city would be thereby disclosed? 

5. "It is sometimes asked whether the raising of a government loan 
to cover ordinary expenditures really causes capital to be lost, since the 
coins received by the government remain in existence, — even remain in 
the country. This objection has no weight whatever." — Pierson's Prin- 
ciples of Economics. 

Show that the statement in italics is correct. 

6. "We pay no million dollars per annum for the carrying of prod- 
ucts between this and foreign countries. Think of it. One hundred and 
ten million dollars in gold coin has gone out of the commerce of this 
country into the commerce of other countries. Can New York stand 
this?" — James G. Blaine in 1881. 

(a) Is it likely that we permanently lost no million dollars in gold 
from our circulation because we hired foreigners to carry our goods? 

(b) Is it likely that we even temporarily parted with that much gold 
on that account? 

(c) Is it likely that as a nation we should have been richer if we 
had done this carrying of products for ourselves? 

7. "I don't see that society as a whole loses anything by the giving 
of a fireworks exhibition costing $1,000. Of course the people who pay 
for the fireworks are just so much out. But then the $1,000 goes to the 
other people who furnish the fireworks so that society as a whole comes 
out even." Criticize. 

8. "My numerous armies promote the circulation of money, and dis- 
burse impartially among the provinces the taxes paid by the people of the 



XIV] SOME MONEY TRUISMS 195 

state." — Frederick the Great justifying his wars in a letter to D'Alem- 
bert. (Quoted from Bullock.) 

Was there anything in the facts stated to offset the sacrifices under- 
gone by the people in paying the taxes ? 

9. "The summer boarders are a great blessing to our little village; 
because they put into circulation a lot of money, which means at least 
temporary prosperity." 

What must we understand this phrase, "put into circulation money" 
to mean, if we accept the above as anything like an adequate explana- 
tion of the prosperity brought by the summer boarders ? 

10. "The individual can get rich only by selling more than he buys 
and saving the surplus in the form of money or bank-credit. So a coun- 
try can increase its wealth only by exporting more than it imports, and 
taking the difference in money." Discuss both parts. 

11. "I am not convinced of the soundness of the orthodox doctrine 
that a country can have all the money it wants and needs, just as it can 
have all the engines, machinery, etc., which it wants. Money is very 
different from other things. It would be easy to give a man all the 
food and clothes he wants; but, however much money you offered him, 
he would take it all gladly." Criticize. 

12. From a Salt Lake supporter of the "Seeing America" movement : 
"We recognize that Americans are annually spending $200,000,000 in 
foreign travel. That practically every dollar of this vast sum is lost 
to the home circulation cannot be disputed." Criticize the last sentence. 



CHAPTER XV 

SAY'S LAW 

The preceding chapter sought to emphasize certain elementary 
principles governing the mechanism of exchange, principles which, 
though little more than truisms, are often overlooked. For exchange 
itself— the process of trade between individuals and communities— 
there are similar elementary principles which are so commonly neg- 
lected or misunderstood as to call for early comment. One of these, 
perhaps the most fundamental of all, has already been given on page 
33, in the proposition that the chief function of exchange is to 
make cooperation and specialization possible. In this chapter, we 
consider a second principle of this kind, one which we shall desig- 
nate Say's Law. 

General Demand Fallacies. — Among the fallacious notions 
in popular thinking that have gained very wide currency are to be 
found a number which 'grow out of misconceptions as to the real 
source of the general or total demand for goods, and as to the 
methods by which that demand is increased or diminished. Several 
types of these fallacious notions may be cited. Thus, governmental 
improvements of all kinds, including even those of questionable 
value, are often supported by business men and others on the ground 
that such improvements increase the total demand for goods. Catas- 
trophes, such as the San Francisco earthquake, disastrous fires, tor- 
nadoes, or even only freezing weather which causes water pipes to 
burst, are frequently accepted as evils not unmixed with good 
inasmuch as the expenditures necessitated for reconstruction and re- 
pairs are supposed to increase the general demand. On the other 
hand, persons of thrifty habits who save a large share of their in- 
comes are frequently the objects of criticism on the ground that 
saving diminishes the total demand for goods. Again, many persons 

196 



XV] SAY'S LAW 197 

seek economic support for the opposition to prison labor, and to the 
employment of women and children in industry, in the argument that 
such employment diminishes the number of jobs open to laborers 
generally. Finally, we have the fears of those who periodically 
prophesy universal overproduction — a universal glut. A true under- 
standing of the nature of the total demand for goods will show that 
these notions are fundamentally unsound. 

Their Argument. — What is meant by those who believe thav; 
governmental expenditures or destructive accidents tend to increase 
the general demand for goods is that they set up chains of purchases 
which zvould not otherwise he made, and, in doing so, bring about an 
increase in the total demand for goods. Now, the trouble with this 
account of the matter is that only one half of it is true. The chain 
of purchases indicated is really set up ; but it does not result in the 
increase in total demand which is claimed. The case for the chain 
is evident enough. Thus, take the example of a householder whose 
roof has been blown off by a severe storm or tornado. He at once 
proceeds to buy shingles and hire carpenters ; the carpenters and the 
lumber dealer, finding their incomes increased, buy more groceries 
and clothing; the grocer and clothier use their unusually large re- 
ceipts to improve their stocks by purchase from the wholesaler, or 
spend more freely for pleasure rides and concerts ; and so on. Thus 
the purchases made by the roofless householder extend themselves 
indefinitely down the line, business quick^s everywhere, and the 
prosperity of the whole community seems to be heightened. 

The Fallacy.- — But, now, what about the second half of the 
popular account of this matter? Does the series of reactions which 
all admit follows the tornado result in an increase in the total de- 
mand? The correct answer is surely a negative one. The money 
which on account of the tornado our householder was compelled to 
spend putting on a new roof would ultimately have been spent any- 
how, though in some other direction ; and, being thus spent, it would 
have created just the same demand for commodities or services. Thus, 
for the sake of simplicity, let us suppose that our householder had 
planned to use the money spent on the new roof in putting a cellar 



198 PRINCIPLES OF ECONOMICS [XV 

under a part of the house which was hitherto not provided with this 
convenience. A necessary result, then, of spending this money to 
repair the broken roof is to prevent it from setting up another chain 
of purchases, starting with those needed to excavate the cellar. This 
other chain would have begun with the hiring of cellar diggers and 
the buying of cement ; the diggers and cement dealers would then 
have spent more for furniture and dental service; and the furniture 
merchants and dentists in their turn would have spent more for 
automobiles and real estate. In short, the purchases made by the 
householder in digging a new cellar would have extended their in- 
fluence endlessly, stimulating business and apparently bringing pros- 
perity into the world, just the same as purchases made to repair a 
roof whisked off by a tornado. Hence the tornado does not increase 
demand in the least, it merely substitutes one chain of purchases for 
another.^ 

Perhaps, however, the objector may argue that our householder 
need not spent the money at all. He may, instead, put it into a bank. 
Truly ; but then money that is put into a bank is not kept there. It 
is loaned out to people who need it to meet immediate expenses or 
who wish to increase the capital which they are employing in their 
business. In any case, they are people who, after borrowing the 
money, will surely use it to buy goods of some kind, and so 'will 
increase the general demand just as much as did spending that 
money to put on a new roof. 

Demand Coincident with Income. — What, now, is the gen- 
eralization to be made from the story of our house owner? Imme- 
diately, it is this : The contribution made by any one person to the 
total demand for goods is, in the long run, bound to be just equal 
to his income, no more and no less. He cannot demand more goods 



* Incidentally, too, we should note that, from the standpoint of the original 
householder, the chain of purchases which would have been started by 
digging a cellar is much more desirable than the one actually started by 
repairing the roof. The second process leaves the man with a house no 
better than before — a house having a roof but no cellar. The first would 
have left him a house already sufficiently well roofed, and improved by the 
addition of a cellar. Hence, while business in general gains nothing from 
the tornado, the householder suffers a positive loss. 



XV] SAY'S LAW 199 

than that income will buy ; he or someone who borrows his money 
is certain to demand as large a quantity as that income will buy. 

Demand Coincident with Product. — But this only starts us 
on our way. What determines the quantity of his money income? 
Broadly speaking, this is determined by the amount of goods or 
services which, under existing legal conditions, is credited to him as 
his product,^ — it being assumed that he is producing something de- 
manded and producing that something in the proper proportion to 
other goods produced. It follows that the contribution to total de- 
mand made by anyone is necessarily equal to the quantity of his 
product; it cannot be greater ; it must be as great. Finally, since the 
total demand of a community necessarily consists of the sum of the 
demands made by the individuals who constitute the community, the 
total demand of that community must equal its total product; it can- 
not be greater ; it is bound to be as great. But these propositions artj 
so important that they must be more specifically defended. 

Demand Not Greater than Product. — Demand cannot be 
greater than product, — cannot, at bottom, include anything outside 
of product. Imagine a shoemaker who makes nothing but shoes 
desiring to obtain a quantity of wheat from a wheat farmer who 
raises no other grain. Obviously, the only way he can hope to 
obtain wheat is to offer shoes — either directly on the barter plan, 
or indirectly through a money medium — in exchange. But these 
shoes which he ofifers he must first have produced — they are a 
product ; hence the shoemaker's demand for wheat cannot include 
anything outside of his product (shoes). Reversing the hypothesis, 
if the wheat grower desires a new pair of shoes, his demand for 
shoes cannot include anything outside of his own product (wheat) ; 
he simply has nothing else to demand with. Now, if this is true 
of two people in their relation to each other, it must be equally 



^ This is not to be taken as meaning that the individual is morally entitled 
to the particular income which he is receiving on the ground that he produces 
it. The product is here whether or not the right man is credited with it; 
and the value of that product determines the volume of demand resulting, 
whoever ought to control that demand. 



200 PRINCIPLES OF ECONOMICS [XV 

true of one person in his relation to society as a whole : the demand 
made by shoemakers for market goods of all kinds can include 
nothing but shoes produced by them and offered on the market ; 
the demand made by wheat growers for market goods of all kinds 
can include nothing but wheat produced by them and offered on 
the market— in each case nothing else will serve as a demand for 
goods in general except something which the individual has himself 
produced. Finally, this proposition, being true of every individual, 
must be true of all individuals taken together. The demand of all 
the people in the community, the total demand, can be no greater 
than the product of all the people of the community, the total product. 
Finally, what is true of each nation in its relations with the rest 
of society, is equally true of all society, of the whole world, in its 
complex, intricate relations with itself. The demand made by all 
society for market goods of all kinds can include nothing but goods 
which the same society has produced and offered on the market. 

Demand as Great as Product. — ^Demand must be as great 
as product, must include all of the goods produced for the market — 
assuming that producers have directed their production in true accord 
with one another's wants. 

It goes without saying that all goods produced for the market 
will be offered in exchange, that being the purpose of their pro- 
duction ; and, by being offered in exchange all these goods come to 
constitute a demand for other goods, in so far as this matter is 
determined by the purpose of their producers. Thus, if the shoe- 
maker produces and puts on the market each year two hundred 
pairs of shoes, then, as far as his intent goes, every one of these 
shoes constitutes a demand for bread, or meat, or clothing, or some 
other good which the shoemaker needs. What is true of the in- 
dividual is obviously true of the aggregate of individuals also. All 
the goods which they all produce constitute a demand for goods, in 
so far as the purpose of the producer affects this matter. 

But we have yet to deal with the proviso "in so far as this 
matter is determined by the purpose of their producers." This 
proviso is needed because the question whether or not a product 
shall form a part of demand depends not only on the attitude of 



XV] SAY'S LAW 201 

the producer of that product, but also on the attitude of those per- 
sons who must be depended on to buy said product. For demand 
involves not only a desire on the part of the prospective buyer, but 
also buying power ; and buying power can be derived from products 
one has to sell only on condition that other people want those 
products, as well as have the power to ofifer other goods in exchange 
for thSm. It follows that a particular product comes to constitute 
a part of the total demand for goods only in so far as it is a product 
for which there is a corresponding demand. For example, the 
two hundred pairs of shoes of our shoemaker constitute a part of 
the total demand for goods only on condition that they are goods 
which other people demand, — stand ready to buy. And this implies, 
it should be noted, that the product in question is demanded in the 
proportion in which it is produced — when we produce a thing we 
do not add to demand in proportion to the volume for our product 
unless we are maintaining the proper proportion between our 
products and other products. 

The points just brought out with respect to the relation between 
demand and the output of goods are so evident that some will con- 
sider it scarcely legitimate to give them the dignity derived from 
formal statement. On the other hand, the continued prevalence 
throughout the larger part of the community of the fallacious no- 
tions which these considerations are designed to correct seems to 
furnish ample ground for any procedure which gives these points 
adequate emphasis. I shall therefore put the proposition we have 
discussed in the form of a principle. This principle, I have taken 
the liberty to designate Say's Law ; because, though recognized by 
many earlier writers, it was particularly well brought out in the 
presentation of Say (1803). This principle may be stated as 
follows : 

Principle — Say's Law. The Ultimate Identity of 
Demand and Product. 

In the last analysis, the demand for goods produced for 
the market consists of goods produced for the market, i. e., 
the same goods are at once the demand for goods and the 
supply of goods; so that, if we can assume that producers 



202 PRINCIPLES OF ECONOMICS [XV 

have directed production in true accord with one another's 
zvants, total demand must in the long run coincide with the 
total product or output of goods produced for the market. 

Say's Law a Long-Run Principle. — In the case of sciences 
— even physical sciences — which deal with highly complicated 
phenomena, many principles have to be affirmed as true in the long 
run; and this frequently applies to the science of economics. Thus, 
everyone knows that the prices of goods tend to equal their cost 
of production ; but everyone also knows that changes in cost do 
not immediately cause corresponding changes in price. Now, this 
comment is applicable to Say's Law to a more than usual degree. 
For this, there is one very substantial reason. It is this : save under 
the most primitive conditions, every exchange of product for product 
is broken into two parts— (i) exchanging one's own product for 
money or bank credits, and (2) exchanging the money or bank 
credits thus obtained for the product of the other man. Obviously, 
an interval of time can be put between these two operations; and, 
as a matter of fact, such an interval, short or long, almost always 
intervenes. 

It follows from the facts just brought out that it is possible 
for us to postpone for a long period, even indefinitely, the second 
part of the operation, thus cutting down for the time being the 
general demand for goods, though we have not cut down the amount 
of production. On the other hand, it is possible that, by getting 
possession of the medium of exchange, money or bank credits, in 
ways other than by exchanging our goods for that medium of ex- 
change, we should perform the second half of the exchange opera- 
tion before having performed the first half. In this way demand 
may he increased enormously, though production has not been in- 
creased at all. 

The qualification of Say's Law made necessary by this peculiar- 
ity of money exchange has little if any bearing on the use of that 
principle to correct the fallacious notions which were used to 
illustrate this discussion. But there are a number of matters in 
respect to which this limitation on Say's Law is of much im- 
portance. One of the lesser of these is closely connected with 



XV] SAY'S LAW ' 203 

one of those fallacious notions which were brought forward in 
the earlier part of this chapter, namely: the idea that by increasing 
governmental expenditure we can increase the total demand for 
goods and so increase general prosperity. Such a device, looked 
at as something to be made use of in ordinary times when economic 
affairs are running along in normal fashion, is, from the standpoint 
of sound economic science, quite impracticable. It could do nothing 
more than deflect demand from some lines of production to other 
lines of production. 

But the case is very different if circumstances have brought us 
to a point where the first of the discrepancies between demand and 
output noted above has become quite general, — that is, a point 
where buyers generally are suspending the second half of the ex- 
change operation. Such a procedure means a general decline in 
demand, hence of necessity a general slackening of productivity all 
along the line. A situation like this is characteristic of the depression 
which follows a business crisis. If, now, under such a condition 
of things, the public authorities step in and undertake a large pro- 
gram of road-making or building construction or harbor improve- 
ments, this will really mean a considerable increase in total demand 
and so an increase in general prosperity.^ 

Much more important cases where the practice of breaking the 
exchange operation into two parts makes possible a change in the 
volume of demand in general which is not preceded by a change in 
the output of goods in general, arise in connection with the phenome- 
non of money and credit. But these are not suited for consideration 
at this stage in our economic study. 

Illustrative Problems 

I. "George Rankin is of course a big fool to spend $400 making 
a mill dam in a creek which is dried up every summer and never has 
enough water to run an ice cream freezer ; but he is doing one good thing, 
— he is making a whole lot more demand for labor and so a lot more 
employment for laborers." 

Explain fallacy. 



It may even be the beginning of a general revival of business. 



204 PRINCIPLES OF ECONOMICS [XV 

2. "There is just so much work to be done. The entrance of women 
and children into the field of labor must drive out an equal amount of 
adult male labor." 

Criticize. (There are no doubt objections of real weight to the ex- 
tension of child and female labor; but this is not one of them.) 

3. "The real cause of the present standstill in trade is the inequality 
of incomes. There can be no effective demand, because those who have 
the money to buy have no unsatisfied wants, while those who have the 
wants have no power to buy." Criticize. 

4. In a certain part of a recent novel, Mr. Blossom, a young painter 
and decorator, is trying to induce Miss Cynthia to give him a job re- 
decorating her house, which is somewhat behind the times in this respect. 
The latter part of the conversation on the matter is as follows : 

" 'Live and let live' is a good enough motto for me." 
" 'Live and let live,' " repeated Miss Cynthia, thoughtfully. "What 
do you think that means?" 

"Why, it's plain enough," said Mr. Blossom, strongly. "You're living 
all right, ain't you? Got enough of everything and something to 
spare . . . ; but you've got to let other folks live. ... If there's any- 
thing you want done that you can't do for yourself, hire somebody that 
can do it ... so they can live, too. If everybody did that right along, 
I guess there wouldn't be so much talk about labor unions and strikes and 
all that sort of thing." 

(a) Would Miss Cynthia's deciding to spend and actually spending 
$600 to redecorate her house increase the employment of laborers gen- 
erally? 

(b) Why can we be certain that everybody is now doing the thing 
which Mr. Blossom thinks they ought to be doing? 

5. Street comment on a cold snap which bursts numerous water- 
pipes : "Hard on householders, sure enough ; but no great loss without 
some small gain. It's a bonanza for Ann Arbor plumbers.''' Is that 
sound ? 

6. Mr. A, having earned and saved $10,000 in gold, buries it in the 
ground. Another, having earned and saved $10,000, spends it on a 
great banquet. Which makes the greater demand for products? Ex- 
plain. 

7. Would we naturally expect events like the San Francisco earth- 
quake and fire to increase the demand for labor in general ? Explain. 



XV] SAY'S LAW 



205 



8. "Economically it is for the interest of every class of producers 
to see the efficiency of other classes of producers increase." Why? 

9. "The extraordinary advance in industrial technique characteristic 
of the last half century has so increased our productive capacity that, 
when things are running smoothly, output is bound, sooner or later, to 
exceed demand, which condition of things invariably leads to a com- 
mercial crisis followed by a general collapse of industry." Criticize. 

10. The Chicago Record-Herald for April 18, 1908, contained the 
report of an interview with the head of one of America's great univer- 
sities, wherein various opinions and statements were attributed to King 
Haakon of Norway. Among these was the following: "I could black 
my own boots if I wished to ; I have done it and therefore know how ; but 
if I did, what would become of the people who make a living blacking 
boots ?" 

Criticize on the basis of Say's Law. 



CHAPTER XVI 

THE PRINCIPLE OF RECIPROCITY 

The Buy-Little Fallacy. — One of the most persistent and 
widespread of errors with respect to economic matters is that, in 
the trade between countries, the condition of maximum desirability 
is to be always selling, never buying, or anyhow selHng as much 
more than we buy as is possible. Almost every year our foreign 
trade reports seem to show a great excess of exports; and this 
announcement always brings out a chorus of congratulatory com- 
ments from our press.^ Now it is quite certain that such one- 
sidedness in trade — selling without buying — would be in the highest 
degree undesirable, if it were feasible. It would not be for our 
advantage to sell more than we buy. But, further, it is quite 
certain that such one-sided trade would not be feasible, supposing 
it to be desirable. Generally speaking, it is not possible for us to 
sell more than we buy, — our exports cannot exceed our imports. 
The second of these propositions is more especially the principle with 
which we are here concerned ; but some comment on the first seems 
called for. 

Not Desirable. — In showing that selling without buying 
would not be desirable, it will perhaps be best to start from the 
standpoint of individual trade. That such trade would not be de- 
sirable for the individual is almost self-evident ; for this proposition 
necessarily follows from the very function for which trade exists. 
That function, as fully explained in our general account of the 



^As will be explained in a latter connection, there are times when, in 
view of the relation of foreign trade to another matter — the stability of the 
monetary system — it is desirable to have an export trade balance. For this 
reason, there is at times some propriety in thinking of such a balance as a 
favorable one. But this is not what the general public have in mind when 
accounting every such balance favorable. 

206 



XVI] PRINCIPLE OF RECIPROCITY 207 

present economic order, is to consummate and therefore to make 
possible that cooperation between us and our fellows which is 
so essential to high productive efficiency. But obviously such co- 
operation would not be accomplished unless each bought as well as 
sold. The advantage which each derives from cooperation is de- 
pendent on getting the products of others, that is, buying. Selling 
his own products is of no significance to him except as it is a 
preliminary to buying the products of others. 

But the reader may be disposed to object that some exceptions 
to this account of the matter must be admitted. First, the seller 
may be a miser who only desires to heap up stores of gold, not 
caring for goods at all, or anyhow not caring for any goods in 
excess of the absolute necessities of life. Secondly, the seller may 
be a prospective capitalist, one who is accumulating surplus wealth 
in order to get from it an income, and who, therefore, saves the 
money he gets from the sale of his goods, instead of buying other 
goods. 

The first of these objections is easily answered as being only a 
seeming exception. The miser is really buying something, — only in 
his case, that something is money. That is, in his thought money 
is not really money — the medium of exchange — but a commodity, 
the particular commodity which his perverted taste leads him to 
desire rather than the kinds of commodities most men desire. 

The unsoundness of the second exception is almost equally 
evident. It is hardly even a seeming exception. The person who 
is accumulating capital is merely postponing the buying half of the 
transaction, — a thing every one has to do when buying expensive 
goods, in that he has to get together from different sales enough 
money to cover the larger amount of money needed to make the 
particular purchase in question. In the end, the capitalist buys 
goods or lends to someone else who buys goods. If he pursues the 
former policy, the only peculiarity of his case is that he buys a 
different kind of goods from those bought by other people, namely 
producers' goods — goods used in the making of other goods. Doubt- 
less his decision to save his money until he has enough to buy 
goods of this sort is of much importance, — may alter greatly the 
course of things; but it does not mean that the money he obtains 



2o8 PRINCIPLES OF ECONOMICS [XVI 

from the sale of his goods is not used for buying other goods, — 
that the second half of the exchange transaction is left incomplete.^ 
The case is not materially different if our capitalist lends his ac- 
cumulations. The borrower will, of course, use those accumulations 
to buy goods. Thus, in the end, the buying half of the transaction 
which began with the original sale will finally be consummated. 

Not Feasible. — We have seen that, in the case of trade be- 
tween individuals, selling without buying could be of no advantage, 
would not be desirable, if feasible. That such one-sided trade 
would not be feasible is quite as certain. We are not able to sell 
without buying; reciprocity is inherent in trade; buying and seUing 
mutually condition each other. The truth of this proposition is 
obvious in the case of direct exchange, barter. Unless I accept the 
goods of the other man, I get no pay for my own. But our proposi- 
tion is no less true when barter is broken into two parts, sale and 
purchase. First, the man who buys from me must be able to sell 
to sorne one in order to get the means to pay for his purchase from 
me. Secondly, this is feasible only provided I make purchases 
from him or from some person or persons with whom he is directly 
or indirectly connected in trade. 

Trade Must Be Reciprocal. — The former of these two propo- 
sitions is so evident that it needs no discussion. The second, how- 
ever, may not at once command assent. For, at first thought, the 
reader may be disposed to say : True, someone must buy from 
my customer, else he cannot get the means to pay me; but it is not 
necessary that I should be that someone ; another customer will 
answer just as well. Doubtless the statement is quite true as far 
as it goes; but it does not meet the dif^culty. Mr. B who buys 
from me may have obtained the means of payment by selling his 
product to Mr. C ; in turn, Mr. C may have obtained the means 



^ Some care is needed in using or interpreting the word "spend." While 
there is no impropriety in attaching to the term the idea that the goods for 
which the money is given are not very necessary, are even goods which 
under all the circumstances we would better do without, we must not let 
ourselves drift into thinking that money paid out for necessary, approved, 
goods is not just as truly spent, if we mean "parted with," used to buy 
something. 



XVI] PRINCIPLE OF RECIPROCITY 209 

of payment for his purchase from B by selHng his product to Mr. 
D ; in turn, Mr. D may have obtained the means of payment for his 
purchase from C by seUing to Mr. E; and so on until the last 
man in the world other than myself has been brought into the chain. 
But that last man must be able to sell to me in order to forge the 
first link in the chain which ends in purchases from me. 

In order to make this point clear beyond question, let us give 
it concrete illustration on the basis of an extravagantly simple 
hypothesis as follows : Our trading is limited to four persons whom 
we will designate A, B, C, and D, respectively. Each sells all 
his product to one other member of the group; each also makes all 
his purchases from one member of the group, this time a different 
one; and each produces and exchanges $10,000 worth of goods. 
Let us now conceive one of the four. A, to be set over against 
the other three, and try to show that, if he ivould sell, he must also 
buy. Let us suppose that B stands ready to take A's $10,000 worth 
of products; C to take B's $10,000 worth; and D to take C's 
$10,000 worth ; while A, by the original hypothesis, is determined 
only to sell, never to buy. What result must follow? Plainly there 
is no one to whom D can dispose of his $10,000 worth of products; 
he, therefore, cannot buy those of C, though he desires to do so. 
As a result, C cannot buy those of B ; and finally, B cannot buy 
those of A. Thus all exchange is stopped because A makes no 
purchases. Let him reverse his policy, and all difficulty at once 
disappears. If A will buy the goods of D, the latter will have 
the means to buy the goods of C, who will then have the means to 
buy the goods of B, who will then have the means to buy the 
goods of A. 

Inter-Group Trade Must Be Reciprocal. — The above argu- 
ment to show that trade between individuals must be reciprocal, 
that we must buy if we would sell, was only preliminary to our real 
task — to show that trade betiveen communities, countries, must be 
reciprocal, — purchases and sales, imports and exports, must balance. 
Before getting into this task, however, we must take a moment to 
make more definite and precise just what is meant by the thesis 
defended. 



210 PRINCIPLES OF ECONOMICS [XVI 

First, the contention is that our foreign trade must show equaHty 
between purchases and sales, imports and exports of services and 
goods, not including money. In general, the money of a country 
is a necessary part of its economic equipment which it can no more 
spare, save for a very brief period, than a household could spare 
its cook stove or beds. Doubtless a country may for a time use 
its money stock to make purchases for which an altogether excep- 
tional need has risen ; but, generally speaking, such a policy will not, 
cannot, be continuous. To this exclusion of money from the list 
of exports and imports to be equalized, however, one exception 
must be pointed out. Standard money is usually a metal product; 
and a product of very uneven distribution in respect to production. 
A few countries mine practically all the gold of the world. This 
being true, most countries must import their supplies of money 
metal, which obviously means that the producing countries must 
export that metal. But, again, this particular product is commonly 
marketed, not as a metal, but as money. Producers sell it directly to 
mints or assay offtces or to banks which dispose of it to mints or per- 
haps at once treat it as international money. It follows that the 
distribution of gold from producing to non-producing countries 
will largely take the form of moving money (frequently gold in bar 
form) from the former to the latter. Accordingly, it is to a certain 
extent necessary to include as a part of the exports or imports of 
a country, money sent out or brought in. This exception, however, 
is commonly of little importance, save when the producing country 
has almost no other product, for example, the Klondike. 

Real Exports and Imports. — A second point w^ith respect to 
the proposition that exports and imports must be equal, which needs 
to be noted, is that the exports and imports had in mind are the 
real, the true, exports and imports, not those reported by the customs 
authorities. The latter are seldom if ever equal, though the former 
must be. The explanation is easy. Customs reports do not, and 
cannot, show all exports and imports. Thus, the true imports of a 
country obviously include everything bought by its people from the 
people of other countries. But some of these things bought from 
other countries cannot, or at least do not, come to the knowledge 



XVI] PRINCIPLE OF RECIPROCITY 211 

of government officials. Of these the most important are (i) goods 
and services bought from the foreigner in his own country, e.g., 
by our people traveling there, and (2) services bought from the 
foreigner and delivered in our own country, but not appearing in 
import lists because as services they do not go through the custom 
house. In short, there are invisible, as well as visible, imports ; and 
it is the sum of both of these which must be equal to the total of 
exports. What has been said of imports applies of course to 
exports. Of these some are visible, some invisible; and it is their 
sum which must equal the total imports. 

Accordingly, if we wish to get a correct balance sheet of the 
exports and imports of a country, we must add to the figures fur- 
nished us by the customs officials, figures from other sources — 
mostly mere estimates — taking into account these invisible exports 
and imports. Thus, if it is true, as some say, that we get trans- 
portation done for us by other nations to the value of $200,000,000 
per year, we must enter on the import side of the balance sheet an 
item like this : 

Services of Carriers $200,000,000 

So, if it is true that we use capital borrowed from other countries 
to an amount which calls for $120,000,000 of interest per year, then 
we must enter on the import side this item : 

Services of Borrowed Capital $120,000,000 

or, in the more usual form: 

Interest of Borrowed Capital $120,000,000 

I hardly need add that the countries selling us these services would 
have to make similar entries on the export side of their balance 
sheets. 

Total Exports: Total Imports. — As a final comment in in- 
terpreting the Principle of Reciprocity, we note that the equality 
of exports and imports which is declared to be necessary is equality 



212 PRINCIPLES OF ECONOMICS [XVI 

between the exports of a country to all other countries and its 
imports from all other countries, — not equality between its exports 
to each country and its imports from that same country. We buy 
from England much less than we sell to her; but, then, we buy 
from some other countries to which England sells an excess of 
goods, much more than we sell to them. In conventional language, 
international trade is triangular. More precisely, it is multiangular. 
But, however many angles it may show, the total in must equal 
the total out. 

Argument for the Principle. — So much for the proper inter- 
pretation of the Principle of Reciprocity. We must now add 
the argument on which that principle rests. Perhaps the simplest 
proof is analogous to that used in establishing the same principle- 
as applicable to the trade between individuals. That is, each must 
buy as well as sell, since otherwise the rest will not have the means 
to buy from it. Thus, let us suppose that the A, B, C, and D 
of our illustration on page 210 represent different countries. Now, 
as before, it is possible that each country should buy from some 
country other than the one to which it sells. It must, however, 
buy from some other country; since otherwise some member of 
the series will not have the means with which to make the purchases 
necessary to complete the series. It is not possible for Country 
A to be just a seller, not a buyer. It must buy from Country D, 
in order that D should be able to buy from C, in order that C 
should be able to buy from B, in order that B, should be able to 
buy from A itself. 

Inequality of Exports and Imports Self-Corrective. — We 

have shown that the foreign trade of a country must be two-sided 
on the ground that only so can those to whom that country sells 
have the means to pay for their purchases, A more difficult, but 
perhaps more adequate, proof is that inequality between the exports 
of a country and its imports is self-destructive, — ^that this fact of 
itself sets up reactions tending to bring about equality of exports 
and imports, so that equilibrium cannot be established until such 
equality of exports and imports has been secured. 



XVI] PRINCIPLE OF RECIPROCITY 213 

Through Rate of Exchange. — The first of the reactions tend- 
ing to bring about the result indicated is the effect produced on 
the course of trade tJirough the particular rate of exchange made 
to prevail by an excess of exports on the one hand, or by an excess 
of imports on the other. As we will remember from the chapter 
on Credit Exchange, the means of payment (the medium of ex- 
change) in foreign trade is credit, the right to claim money in other 
countries, — exchange, as it is technically named. It follows that the 
export dealers of any country will have such exchange to sell; while 
importers will need to buy such exchange. As a consequence, a 
falling rate of exchange will tend to lower the profits of exporters, 
since the exchange they have to dispose of brings in less ; while that 
same falling rate will tend to raise the profits of importers, since 
the exchange they need to buy will come cheaper.^ But any cause 
which lowers the profits of exporters and raises those of importers 
will obviously tend to diminish the dealings of the former and in- 
crease those of the latter, that is, will tend to diminish exports and 
increase imports. Finally, an excess of exports is just the cause 
which tends to lower the rate of exchange ; since such excess means 
that there is more exchange offered for' sale than the demand will 
take up. It thus appears that an excess of exports sets up a chain 
of causation tending to eliminate that excess: said excess makes a 
lower rate of exchange ; which lowered rate makes exporting less, 
and importing more, profitable; which decreases exports and in- 
creases imports ; which finally eliminates the excess of exports, that 
is, brings exports and imports to an equality. An analogous course 
of reasoning would show that an excess of imports must tend to 
disappear, — must destroy itself. 

Through Money Movements. — We have seen that an excess 
of either exports or imports is self-destructive or self-corrective, 
through its influence on the rate of exchange. Such an excess is 
self -corrective also through its influence on the movements of 
money.* If a country is exporting more than it imports, the ex- 



^ See problems 11 and 12, page 187. 

*This topic is more fully discussed in Chapter XXXIV. 



214 PRINCIPLES OF ECONOMICS [XVI 

change dealers of that country will presently find themselves creditors, 
by a considerable balance, of the exchange dealers of other countries. 
Such a state of things may be allowed to continue for a few 
weeks through temporary loans to their correspondents in the debtor 
countries. But, in general, such balances are not permitted for 
any considerable period in international trade; and, in consequence, 
the continuance of an export excess soon leads to a movement of 
money toward the exporting country to make good the balance 
owing that country. Such a movement, however, presently causes 
the reserves of the banks to become excessive, makes borrowing 
easy, inflates business and buying in general, with the result that 
prices in general rise. An exactly opposite course of causation in 
the importing countries results in a general lowering of prices. But 
the raising of prices in the exporting country and the lowering of 
prices in the importing countries make the former an undesirable 
market to buy in, and the latter a desirable one. In consequence, 
the exports of the country having an excess of exports tend to 
decline while its imports from other countries tend to expand. Thus, 
again, an excess of exports is self-corrective. Exports and imports 
tend to become equal automatically. 

Let us now embody the result of this long discussion in a formal 
principle as follows : 

Principle — The Principle of Reciprocity.^ 

Exchange between communities, as between individuals, 
is necessarily reciprocal; and, speaking broadly, the total of 
goods {not including money) sold by any community to all 
other communities must in the long run equal the total of 
goods {not including money) bought by that community 
from all others, save that there will usually tend to be a 



° The Principle of Reciprocity here laid down should not be confused 
with the policy of reciprocity much advocated and occasionally practiced 
in this country. The latter, as indicated, is a policy in the conduct of a 
nation's commercial relations, not a natural law governing phenomena. 
Further, as a policy reciprocity has its chief theoretic basis in alleged natural 
laws which are quite inconsistent with the Principle of Reciprocity. Most 
advocates of the policy of reciprocity are more or less pronounced dis- 
believers in the Principle of Reciprocity. 



XVI] PRINCIPLE OF RECIPROCITY 215 

slight excess of goods exported from communities not pro- 
ducing standard money metal and a more or less consider- 
able excess of goods imported into a country producing 
standard money metal — it being assumed that the distribution 
of population among different communities remains substan- 
tially unchanged. 

Illustrative Problems 

1. "Another important reason for keeping our fleets as far as pos- 
sible in our own ports is that under this pohcy the money they spend for 
ordinary supplies goes to our own people." 

Explain what the writer probably meant and criticize it. 

2. "To the same extent that the home market is wrested from for- 
eigners and given to protected home producers, the foreign market is 
wrested from unprotected home producers." 

Explain and defend the statement. 

3. "When I came to Marblehead they had their houses built by 
country workmen, and their clothes made out of town, and supplied them- 
selves with beef and pork from Boston, which drained the town of its 
money/' — Barnard's Autobiography. 

Criticize the part in italics. 

4. From a supposititious editorial of a Benton Harbor newspaper : 
"The annual influx of students and other outsiders into the fruit belt 
to engage in fruit picking and packing is an abuse which should be 
stopped at once. These people, consume very little, saving their money 
to take back to Ann Arbor, Chicago, and the other places from which 
they came. Thus, while making large sums off us, they give little or 
nothing to the support of our industries." Criticize. 

5. "One reason for our almost constant excess of exports is that we 
are enterprising and so always opening up new markets." 

Objector: "Opening up new markets might increase our exports but 
could not increase our excess of exports unless somebody cheated us." 
Defend the second statement. 

6. Remarks of a leading Congressman when it was announced that 
the Canal Commission would purchase supplies wherever they could 
be secured most cheaply : "The President should be able to see the de- 
sirability of purchasing the supplies in this country alone, because thus 



2l6 PRINCIPLES OF ECONOMICS [XVI 

employment would be given to American capital and labor instead of 
foreign." Explain fallacy. 

7. "The chief reason for our excess of exports is to be found in the 
fact that the things which we sell are more necessary to our neighbors 
than the things which they sell are to us." Criticize. 

8. "The true way to quicken foreign demand (for British goods) was 
to open the ports to that foreign supply with which they paid us for 
what they bought from us." — Morley's Gladstone, Volume i, page 267. 

Show that the above is sound doctrine. 

9. "If we buy rails from England, we get the rails of course, but 
they get our money; while, if we buy the rails at home, we have the rails 
and the money, too." 

(a) Is there any reason to expect that our buying rails' in England 
would carry off our regular stock of money ? Explain. 

(b) Substitute "cotton" for "money" throughout the above quotation, 
and show the fallaciousness of the doctrine. 

10. "The trade of the United States shows an excess of exports, 
because it is a large resourceful country which has to supply other coun- 
tries with raw materials." Criticize. 

11. "I have always believed that free trade would secure the greatest 
general prosperity, provided that all countries would practice it. But, if 
neighboring countries are bound to maintain protection, it is only fair to 
ourselves to do the same." 

(a) What is the real economic evil of having our neighbors shut 
out our goods ? 

(b) Would we better matters by shutting out theirs? 

12. A Detroit physician who has a son in the University at Ann Ar- 
bor requires the latter to buy his clothes and other supplies just as far 
as possible in Detroit, on the ground that, since his income is earned in 
that city, it ought to be spent there. 

(a) Has the father placed himself under obligations to the people 
of Detroit by earning an income from them? 

(b) Supposing the distribution of population unchanged, would De- 
troit as a whole get any more employment on the one plan than on the 
other ? 

13. A Western newspaper, anxious to hinder the people of the com- 
munity from buying outside, represents a silver dollar as appealing to a 



XVI] PRINCIPLE OF RECIPROCITY 217 

home dentist about to send it to the Montgomery Ward Company of 
Chicago, in the following strain : 

"Now, look here, Doc. If you'll only let me stay in this town I'll 
circulate around and do you lots of good. You buy a big beef steak with 
me, and the butcher will buy groceries, and the grocer will buy dry goods, 
and the dry goods merchant will pay his doctor bill with me, and the 
doctor will spend me with a fq,rmer for oats to feed his buggy horse, and 
the farmer will buy fresh beef from the butcher, and the butcher will 
come around to you and get his tooth mended. In the long run, you see, 
I will be more useful to you here at home than if you send me away 
forever." 

(a) Clear up once more the fundamental errors in all talk of this 
kind. 

(b) Show that, even if we admit the principle implied in the quota- 
tion (that only the money spent at home can complete the circuit so as to 
get back to the original spender), only a very small portion of the dollar 
could get back to the dentist. 

14. English people own much capital which is earning interest or 
dividends in other countries. What effect does this fact tend to have on 
England's exports or imports? 

15. "If it were possible for one county to provide by law or other- 
wise that no dollar which came into it could be sent out, within two years 
the county would be so much richer than its neighbors that they would 
begin to wonder, etc." — Western newspaper. 

(a) What do you suppose are his reasons for expecting such a 
policy to produce the great prosperity predicted? 

(b) Show that his great expectations are unreasonable. 

(c) Show that the policy in question would be likely to make the 
county poorer rather than richer. 

16. "You admit that it would increase the productive power of a 
given county to have a man with one hundred thousand dollars move in, 
bringing his money with him. How, then, can you deny that the county 
would grow richer if it could and should for three or four years stop all 
money which came in from going out?" 

Show that we are guilty of no inconsistency in admitting the one 
contention and denying the other. 

17. The following was taken from a country newspaper in 1908: 
"It appears to this paper that all this severe criticism ... of Mrs. How- 
ard Gould's requiring $70,000 a year to pay her expenses is quite un- 



2i8 PRINCIPLES OF ECONOMICS [XVI 

called for. What's the difference, anyway? If she and her folks have 
the 'dough,' let them spend it as fast as they like. That's better than 
hoarding it. When the money is spent it goes to some one and gets into 
circulation. We people whom circumstances compel to live on 30 cents 
a day would be glad to see all the old millionaires spending each $70,000 
a year on himself, or ten times that amount if he wants to. The money 
isn't lost." 

(a) State clearly what advantage the writer of the above probably 
imagined that the public derive from the extravagance of Mrs. Gould 
and other rich people. 

(b) Explain the fallacy in the doctrine. 

(c) Show that the last sentence of the quotation is of no significance 
in the matter. 

18. "The so-called Principle of Reciprocity is all rubbish. It is child's 
play to show that we can sell to other countries even if we do not buy 
from those countries. No British buyer of American goods asks the 
question whether America buys British goods. His only question is: 
'Does this article in character and price suit me?' If so, he buys it. 
Further, it is a matter of common knowledge that a country will often 
buy a great deal from some other country, even though it sells little or 
nothing to that other country. Thus Germany has no better customer 
than England, whose goods she keeps out by tariff. So we buy largely 
from Brazil, though we sell her very little." 

(a) State the Principle of Reciprocity. 

(b) Show that the arguments against this principle contained in the 
above quotation have no bearing on the case. 

19. "Our neglect of the South American trade is simply scandalous. 
We buy a large amount from Brazil every year but setl her almost noth- 
ing, leaving her markets to be gobbled up by England and other European 
countries. We ought to subsidize a great merchant marine running to 
South America, and drive Europe out of a market which is naturally 
ours." 

Show that a very plausible argument can be made for the contention 
that we should be cutting off our own noses if we were to drive Europe 
out of the markets of South America. 

20. "We are going to get from Germany an indemnity of forty or 
fifty billion dollars; but we are not going to let her utilize this fact 
to build up her industries again by exporting billions of dollars worth of 
goods to other countries. We shall take our indemnity in gold, not 



XVI] PRINCIPLE OF RECIPROCITY 219 

goods." This was the sort of talk much heard in the Allied countries, 
particularly France, during the winter of 1918-1919. 

Show that, even if the Allies were to insist on being paid in gold, this 
would necessitate letting Germany export billions of dollars worth of her 
products, it being remembered that Germany has less than $300,000,000 in 
gold and is not a producer of that metal. 



CHAPTER XVII 

THE LAW OF COMPARATIVE COSTS 

We come now to a fundamental principle of trade which is 
somewhat more difificult than the two we have already considered, 
and yet is so fundamental as to call for treatment in this connection. 
It is commonly known as the Law of Comparative Costs. This 
principle may be looked on as a formal answer to the question: 
What condition must be fulfilled to make it worth our while to 
cooperate with our neighbors, individual or national, by engaging 
in trade with them? Not a few economists would very likely be 
disposed to affirm that there is really no necessity of answering the 
question in any other than the common-sense way. It is worth our 
while to trade with other communities when and only when their 
prices make it profitable to do so. "We can go deeper," he might 
say, "but we do not need to. There is no better index to the fulfil- 
ment of the deeper conditions necessary to make exchange-coopera- 
tion profitable than that given by comparative prices." 

How the Question Arises. — This solution of our problem, 
however, meets serious difficulties. A gre!5t many people are con- 
vinced on personal grounds that it is not a good thing to have trade 
go just where it naturally would in view of price conditions; they 
usually want to shut out some goods which, if we had regard only 
for prices, we should naturally buy from other people. They find 
no difficulty, either, in adducing excellent reasons, of a political and 
social sort, why we should do this. But, in order to bolster up 
their cause they usually bring forward arguments which they be- 
lieve to be based on fundamental economic principles. They try 
to seek out some reason lying behind the surface fact of a favorable 
price, and this reason usually concerns our ability to produce for 
ourselves the thing we buy as well as, or better than, the country 



XVII] LAW OF COMPARATIVE COSTS 221 

from which we buy it. If we can produce it more easily than the 
other people, we have a sure case for the wisdom of producing 
it ourselves. If we can produce it just as easily as the other people, 
the same conclusion is almost as certain. Even if we cannot produce 
it as easily but can only just produce it, many people are disposed 
to declare that we ought not to buy it from others. But these ideas 
are in part at least erroneous, and so the economist is forced to make 
a deeper analysis than would otherwise be necessary. 

Simplest Case. — One condition under which trade between 
two countries would surely be profitable is that each country should 
be able to produce the commodity it sells at a cost which is abso- 
lutely smaller than its cost in the other country, meaning by cost, 
labor, waiting, and other primary factors. Thus, let us suppose 
that in country A broadcloth is produced at a cost of only 3 days' 
labor (letting labor represent all real costs), while in country B 
it costs 4 days' ; and that, on the other hand, iron costs in country 
B only 16 days' labor, while it costs 18 days' in country A. That 
is, broadcloth is produced at smaller absolute cost in A ; iron at 
smaller absolute cost in B. Under these conditions, we will surely 
believe that A will profit by using broadcloth to buy iron from 
B ; and the latter will profit by using iron to buy broadcloth from 
A. But why will this be true? What is the real economic ex- 
planation of the matter ? For this we need to go a little deeper. 

If we look at the figures of our example from another standpoint, 
we note that the people of A spend only one-sixth as much labor 
on the cloth as on the iron ; while the people of B spent one- fourth 
as much on the former as on the latter. But it is a commonplace 
of business, though not yet treated in our discussion, that the com- 
parative prices of things must show at least a rough correspondence 
with their costs of production. It follows that, in country A, a 
yard of cloth will be worth only one-sixth as much as a ton of iron ; 
while, in country B it will be worth one-fourth as much. Or, if we 
look at the matter primarily from the standpoint of iron, a ton of 
this will be worth, in A, six times as much as a yard of cloth ; while, 
in B, it will be worth only four times as much. In short, if each 
commodity be measured in terms of the other, broadcloth is much 



222 PRINCIPLES OF ECONOMICS [XVII 

cheaper in A, iron much cheaper in B. It follows that B would 
profit by buying the cloth it wants in A, provided payment could 
be made in iron; while A would profit by buying the iron it wants 
in B, provided payment could be made in cloth. But manifestly 
these two desirable possibilities exactly fit each other. B wants 
to use its iron to buy A's cloth ; and A wants to use its cloth to buy 
B's iron. Evidently, then, trade between the countries would be 
profitable under the condition assumed, namely, that each can pro- 
duce the commodity it exports more cheaply than the other can 
produce that commodity. 

Difference in Absolute Cost Unnecessary. — It seems probable 
that the most important cases of profitable trade between different 
countries are included under the case just considered, — each coun- 
try is superior in respect to the commodity it exports and inferior 
in respect to the commodity it imports. But, as was long ago 
brought out, this statement does not cover all cases, and is in fact 
misleading. If we stopped here the reader might very naturally 
conclude that trade would pay only when the condition just ex- 
plained was present, and that we ought never to buy a thing from 
other countries if we could produce that thing as cheaply as those 
other countries. 

Case of the Individual. — The unsoundness of the doctrine 
as applied to an individual is at once evident. Here, for example, 
is a lawyer who very likely can mow his lawn, cultivate his garden, 
and take care of his furnace much better than the person or persons 
whom he hires to do these things. Nevertheless, he devotes himself 
to the practice of his profession, and buys the services named from 
other people. And he of course acts wisely in doing so, for it is 
plain that he gains most by using his whole time and energy on the 
kind of work for which he is best fitted. He is not interested in 
the fitness or unfitness of his neighbor as compared with himself, 
but rather in the degree in which his own fitness in one line is greater 
than his fitness in another line. So long as he can find a market 
for his possible output, he would better devote his time entirely to 
doing the kind of work for which he is preeminently fitted, and get 



XVin LAW OF COMPARATIVE COSTS 223 

his supplies of other things from his neighbors, even though he 
can make those other things better than his neighbors. 

What the lawyer cares about is not whether he can produce the 
thing he buys less cheaply than the man from whom he buys it, 
but whether he can produce that thing which he himself sells more 
cheaply than he can produce the thing which it will buy for him. 
In other words, what is the cheapest way for him to get shoes — 
to produce them himself or to produce legal services, sell these, 
and use the proceeds to buy shoes? It is his comparative efficiency 
in the two directions which determines his conduct. Put in another 
way, it is the comparative cost to himself of producing the two 
different commodities which determines whether he shall produce 
a given one or buy it. He naturally chooses to produce the one 
which has the lower cost to himself. 

Case of a Nation, — Now, a community or nation is in this 
respect no different from an individual. England, let us say, pro- 
duces principally cloth, getting most other goods through exchange 
with outside communities. England is really better fitted to produce 
some of the things she buys than are the people who actually do 
produce them, and she is, moreover, perfectly well aware of the 
fact. 

But, like our lawyer, England, though superior to other coun- 
tries in many respects, confines her productive efforts to the 
industry or industries wherein she is most superior. The condition 
which makes her desire to trade is not a certain ratio between her 
own efficiency and that of other countries, but rather a certain ratio 
between her own efficiency in one industry — put in terms of cost — 
and her own efficiency — put in terms of cost — in other industries. 

But this alone would not make possible trade between England 
and other countries. These countries must also have a motive for 
wanting to trade. How is this possible ? England, we have assumed, 
is superior all along the line; hence China must be assumed to be 
inferior all along the line. She is inferior in cloth, inferior in iron, 
inferior in potatoes. But while England, being universally superior, 
has a motive for trading, we must now find a motive for China, in 
spite of the fact that she is universally inferior. 



224 PRINCIPLES OF ECONOMICS [XVII 

Though not so evident on the surface, this problem easily clears 
itself upon a little reflection. If China is inferior to England in 
respect to both cloth and iron, she will surely find an advantage in 
specializing where her inferiority is less. If she is three-fourths as 
efficient in producing iron, and only one-half as efficient in producing 
cloth, it will pay her to produce iron and buy cloth. Here again the 
matter which the country is interested in is, not the cost of each 
commodity at home, as compared with the cost abroad, but the 
comparative cost at home of the two commodities. 

Thus, both the country universally superior in production, and 
the one universally inferior, might have adequate motive for resort- 
ing to exchange. Before exchange could actually take place, of 
course, the particular exchange that is desirable for one country 
would have to be the same that is desirable for the other. The 
differences in comparative efficiency should be complemental to each 
other. If England is more efficient in the production of cloth than 
in the production of iron, while China is more efficient in the produc- 
tion of iron than in that of cloth, then- it will be feasible for them 
to effect the specialization which would naturally be profitable to 
them; for the greater superiority of the one just fits the smaller 
inferiority of the other. By using its cloth to buy iron, England 
takes advantage of its greater superiority; while, by using iron to 
buy cloth, China takes advantage of its lesser inferiority. 

The principle which embodies the essential points brought out 
above has long been known as the Law of Comparative Costs. It 
may be formally stated as follows : 

Principle — The Law of Comparative Cost. 

Broadly speaking, in order to make the exchange of two 
commodities between two countries profitable it is only 
necessary that the comparative cost of the commodity ex- 
ported by either of the tzvo countries should be less in that 
country than in the importing country. 

Specific Proof. — The general argument for this principle has 
perhaps been developed as fully as is necessary or desirable in the 
explanation leading up to its statement. However, it may be well 



XVII] LAW OF COMPARATIVE COSTS 225 

to add a proof analogous to that just used in the case where each 
country was supposed to be superior in respect to the product it 
exported. Thus, let us change that hypothesis so as to make the 
cost of iron in A 30 days' labor and that of broadcloth in the same 
country 5 days', leaving costs in B the same as before : 16 days' 
and 4 days'. On this hypothesis, we shall have the same com- 
parative values of iron and cloth in each of the countries as under 
the former hypothesis. That is, iron will be worth 6 yards of 
cloth in A, and only 4 yards in B ; while cloth will be worth ^ 
of a ton of iron in B and only 1/6 in A. It will, therefore, pay 
the people of A to use their cloth to buy iron in B ; and will pay the 
people of B to use their iron to buy cloth in A. Thus the trade 
which was profitable to both under the first hypothesis continues to 
be so, though A is inferior, B superior, in both industries. 

Before leaving this topic one further comment should be added. 
We have all along spoken merely of the reciprocal trade of two 
countries. As a matter of fact, most international trade is not of 
any such directly reciprocal character — it is triatigular, or multi- 
angular. England sells cloth to Brazil ; Brazil sells beef and hides 
to America; America sells cotton and iron to England. At bottom, 
however, although a complete demonstration of the fact might 
prove very difficult, the cases of reciprocal and multiangular trade 
are substantially the same. The condition which makes specialization 
and exchange profitable is a difiference between the comparative real 
costs to one country of the things exchanged and their comparative 
real costs to other countries. 

Illustrative Problems 

I. Country A can produce pig iron at a cost of 10 days' labor per 
ten and broadcloth at a cost of 5 days' labor per yard. Country B can 
produce the iron at a cost of 14 days' labor and the cloth at a cost of 6 
days' labor. 

(a) What, in this example, are the comparative costs which our 
principle tells us must be unequal to make exchange pay ? 

(b) Prove in detail that, if transportation and all costs other than 
labor be ignored, exchange of these two products will pay. 

(c) Which commodity will country A export? 



226 PRINCIPLES OF ECONOMICS [XVII 

2. Make a hypothetical case yourself and prove with it that ex- 
change will not pay if comparative costs are equal. 

3. "We may often by trading with foreigners, obtain their commod- 
ities at a smaller expense of labor than they cost the foreigners them- 
selves." 

(a) Show with illustration that this is true. 

(b) Show how such a trade could be profitable to the foreigner. 

(c) What do you suppose is the ultimate cause which explains the 
fact that such trade can be profitable? 

4. "We know that England can make ships more cheaply than we 
can, and so we should let her do the ship building and turn our capital 
to such things as we can do better than she can." 

Assuming the conclusion — that we should turn our capital to other 
things — to be correct, the reason given for it is not entirely satisfactory. 
Explain. 

5. "It seems probable that Southern California would be very foolish 
to devote itself to raising wheat even it could raise twice as much wheat 
per acre as any other district in the world." Why ? 



CHAPTER XVIII 

SPECULATIVE TRADING AND INSURANCE 

In this chapter we purpose to comment briefly on two forms of 
economic activity a knowledge of which has not seemed quite essen- 
tial to the development of our study, but which, certainly, we ought 
not to ignore altogether. These are Speculative Trading and In- 
surance. 

Risk-Bearing a Necessary Function. — It must be manifest 
by this time that risk, the risk of loss, both physical and economic, 
is an ever-present element in economic life. There is constant 
danger that goods shall undergo physical destruction or deterioration, 
and danger that the value — the economic significance — of goods shall 
decline. Now these risks, being ineradicable elements in economic 
life, individuals, or society as a whole, must in some way bear them. 
As has already been brought out again and again, a large number 
of the risks incident to productive activity are borne by the central 
figure in production, the entrepreneur. It has indeed been main- 
tained by some writers that not only the entrepreneur's greatest, 
but his only, function is the assumption of the risk of production. 
The position on this point taken in the present text has been some- 
what less extreme. We recognize that the assumption of the re- 
sponsibility of production involves some other burdens as well as 
risk-taking, including some very general types of labor. Neverthe- 
less it must be admitted that the chief part of the entrepreneur's 
task or function is to bear risk. 

Types of Risk. — Again, as has been explained in other con- 
nections, risks are chiefly of two types: (i) those which regularly 
recur and so are calculable and (2) those of irregular nature which 
cannot be reduced to any law of recurrence. The entrepreneur's 

227 



228 PRINCIPLES OF ECONOMICS [XVIII 

function in risk -bearing is especially connected with the second type. 
But he is not the only one who contributes to the bearing of this 
burden. In fact, no economic person can be completely rid of it; 
and one person especially, the man who engages in speculative trad- 
ing, shares in it very largely. Our first section, therefore, is given 
to an account of speculation or speculative trading. 



Speculative Trading 

Nature of Speculation. — The nature of speculation can best 
be realized by contrasting it with related functions and operations. 
As already noted, speculation is akin to the function of the entre- 
preneur in that it assumes non-calculable risks. It differs, however, 
in that it frequently divorces this assumption of risk from owner- 
ship; whereas the distinctive mark of the risk-bearing of the entre- 
preneur is that he assumes that burden by the process of becoming 
the owner of the goods. He assembles the various productive ele- 
ments necessary for bringing a commodity into existence and accepts 
the responsibility from first to last, including the ownership of the 
products when completed. The speculator in the narrow sense does 
not necessarily do this ; in fact, a very characteristic feature of his 
trading is the cutting apart of these two functions. Thus men who 
purchase wheat in large amounts and store it for sale at a future 
time commonly turn over to someone else the burden of bearing 
the risk of possible loss between the purchase and the sale of such 
wheat by selling against it other wheat for future delivery. 

Speculative Trading and an Ordinary Business. — Again, spec- 
ulative trading is distinguished from ordinary or so-called legitimate 
business in that it expects to make a profit out of changes in the 
prices of commodities in the same market ; whereas ordinary trade 
expects to get its profit out of price differences in different markets. 
To illustrate, the speculator in wheat on the Chicago market buys 
wheat today expecting to sell it at a later date in the same market 
when the price shall have advanced. He very likely sells to another 
person like himself who deals in the goods for the same purpose 



XVIII] SPECULATIVE TRADING AND INSURANCE 229 

of making a profit through purchase and sale. In contrast with this 
we have ordinary or legitimate trading when a commission house 
buys wheat from someone really having it for disposal and sells 
that wheat, not to some other dealer, but to a miller who wishes 
to turn it into flour. That is, he buys in the wholesale dealers' 
market and sells in the millers' market. Between the prices of these 
two markets, there is a recognized and admittedly legitimate differ- 
ence at the same time. This difference is the source of the profit 
to the dealer. Another way of characterizing legitimate or ordinary 
trade is to say that it carries the goods forward one stage on the 
way from the original producer to the ultimate consumer ; whereas 
speculation merely tosses it back and forth between dealers at the 
same stage, — the wholesale market stage. 

It ought, perhaps, to be added to the above account of this 
matter that some admixture of speculative trading is often present 
in ordinary business or at any rate may be so present. Ordinary 
dealers of speculative temperament will every now and then load 
up with an unusually large stock of some commodity, the price of 
which, in their opinion, is likely to advance. This is in the strictest 
sense speculation, not what is commonly called legitimate business. 

Speculation and Gambling. — We have distinguished the risk- 
bearing of the speculator from that of the entrepreneur and his type 
of dealing from that of the ordinary trader. We need also to dis- 
tinguish speculation from gambling with which it is often identified. 
Gambling, as pointed out in other connections, has, from the eco- 
nomic standpoint, this distinguishing mark : it involves the assump- 
tion of a needless risk. In many cases the risk is created for the 
occasion. For example, the gambler throws a pair of dice out of 
a box, betting on which side will turn up. On the other hand, 
gambling may take place in connection with chances which naturally 
exist, for example, in the outcome of some notable series of events, 
an election or a war. But although the chance is here of natural 
origin, the assumption of economic risk with respect to that chance 
is not of natural origin. It is entirely artificial. It is, for the 
moment, uncertain whether Mr. Cox or Mr. Harding will be 
elected ; the uncertainty, the chance, is here anyhow ; but I am not 



230 PRINCIPLES OF ECONOMICS [XVIII 

driven to assume any economic risk in connection with this uncer- 
tainty. In contrast with gambling, speculative trading not only 
involves inevitable uncertainty and chance, it also involves a neces- 
sary economic risk. The price of wheat may change between Septem- 
ber and March. In fact it is practically certain to change. No man 
experienced in such matters will anticipate the recurrence of pre- 
cisely the same price six months from date. This element of uncer- 
tainty or chance must necessarily entail loss to someone. If it 
should be a fall, the present owner will lose ; if it should be a rise 
the persons who will need to purchase the wheat will inevitably 
lose.- Speculation is, therefore, not gambling, but, within limits, the 
performance of a necessary economic function. 

Characteristics of Exchanges (Bourses).^ — The most thor- 
oughgoing forms of speculative trading are carried on in special 
markets, of which the wheat, cotton, and stock exchanges — called 
bourses on the continent of Europe — are the most conspicuous ex- 
amples. These markets have as their most notable characteristics 
the following: 

(i) Trading in common. The majority of the dealers taking 
part are brought together in one place at the same time; buyers 
competing with buyers and sellers with sellers. 

(2) Another characteristic is open-trading. There is no 
privacy as respects the dealings. The amounts, prices, and so on 
are at once announced and recorded by the proper officers. 

(3) The trading is through official dealers, brokers, as they 
are ordinarily called. 

(4) The dealings are usually on a very large scale. 

(5) The major part of the trading is speculative. There is, 
of course, some selling by persons who have produced the goods 
and brought them to the market for disposal, and so there are some 
persons who have come to the market to buy for actual use outside. 
This last is illustrated by men in the milling district who purchase 
their wheat supply in large amounts at these exchanges. But the 
major part of the dealings, probably more than 90 per cent of them, 
are carried on by men who are engaged in speculation as such. By 
this is meant that they are not, if buyers, intending to make any 



XVIII] SPECULATIVE TRADING AND INSURANCE 231 

use of the product, while, if sellers, they are not producers or 
ordinary middlemen who are bringing the goods to market. What 
they are doing is attempting to make a gain, if buyers, by getting 
at one price and presently selling at a higher one. If sellers, they 
have already purchased at a low price and are now reaping the 
gain resulting from the advance. Or they may be selling for future 
delivery, agreeing to deliver the goods at some future date, con- 
fident that they will be able to make the necessary purchases at the 
time of delivery at a lower price than that agreed upon. 

(6) This last statement suggests another characteristic of 
produce speculative trading, namely, dealing in futures. By this is 
meant nothing more than contracting to deliver or to accept at some 
future time a quantity of goods at a price now agreed upon. Such 
contracts for future delivery are of course present in all lines of 
business. We order a suit of clothes, we order wood, or coal, to 
be delivered at some future time ; the contractor orders structural 
steel and lumber in advance of the time when he will need it. 
But the future trading of the speculative market differs from these 
cases in that it is not something occasional, growing out of a special 
need of the consumer or producer, but is systematically and con- 
stantly entered into for the sake of the possible profits to be obtained, 
or for some other ends which will be explained in a moment. 

Technique of Speculative Market. — It may contribute to our 
understanding of this matter to note some of the technique of the 
speculative market. As stated above, the dealers directly concerned 
in the processes of buying and selling are known as brokers, and they 
are constantly taking and fulfilling orders. (The brokers, however, 
are usually supposed to refrain from personal dealings, and to buy 
or sell only on the account of other persons.) The real dealer in 
the transaction is commonly some outside party, perhaps located in a 
remote city. 

Some of the dealers on the market habitually deal with the ex- 
pectation of making a profit from a rise in prices ; that is, they buy 
today with the intention of selling later when prices have advanced. 
They are known as bull speculators, or simply bulls. In contrast, 
some dealers habitually anticipate and deal with an eye to a fall in 



232 PRINCIPLES OF ECONOMICS [XVIII 

prices. Such dealers sell for future delivery, — "go short," is the 
expression frequently used. They agree to deliver certain goods 
which they do not at the present moment own. Dealers of this type 
are known as bear speculators, or simply bears. 

A special feature of short selling on the stock market is the 
borrowing of stock. On most stock exchanges, in this country at 
least, the rules require the delivery of the goods sold within twenty- 
four hours. By hypothesis, however, the dealer is not in possession 
of those goods. It, therefore, becomes necessary that he should 
borrow from those persons who do own the required stock. As a 
rule, he has no difficulty doing this because the owners are glad 
to be released of the burden of interest-bearing which ownership 
involves. Circumstances may arise, however, under which the de- 
mand for stock to deliver on short sales is so great that it is prac- 
tically impossible to find enough stock to meet the emergency. The 
result in this case is a crisis to the bears in which great sums are 
lost. 

Marginal Trading. — Another bit of technique of importance 
is the so-called margins and marginal trading. Everywhere in busi- 
ness life there is dealing on borrowed capital. Probably the majority 
of traders in all highly-developed countries depend on the capital 
of other people for a considerable part of that which is needed in 
their business. They borrow outright from capitalists on personal 
notes, or they meet any particular bill from wholesalers by raising 
a special sum for that emergency. Essentially the case is no differ- 
ent in margin trading on exchange. That is, the purchaser wishes 
to buy five hundred shares of Pennsylvania stock and has not more 
than a tenth of the capital necessary to do so. He naturally desires 
to borrow the rest of the money needed from someone else. This 
is particularly easy in stock transactions or speculative transactions 
generally for the reason that the security is readily realized upon and 
very efficient machinery for facilitating the process has been built 
up. The man who wishes to make such a purchase, therefore, de- 
posits with his broker that portion of the purchase price which he 
himself expects to pay, authorizing the broker to borrow the rest 
of the money needed. The sum which he deposits with his broker 



XVIII] SPECULATIVE TRADING AND INSURANCE 233 

to cover his part of the money advanced is called a margin and 
trading of this type is known as marginal trading. 

As explained above, this borrowing is in essence no different from 
borrowing in other lines of business. In practice, however, it is a 
more dangerous type. This is partly, of course, due to the more 
dangerous character of the business. In addition, the facilities given 
tempt dealers to go into the speculation on a much larger scale 
than their own capital will warrant. It is always provided that the 
broker can dispose of the stock he holds as security for the loan 
whenever his client fails to maintain his margin, and this of .course 
makes that broker perfectly willing to lend to the limit of reason- 
ableness. 

The last remark suggests two or three other technical phrases 
employed in speculative trading. To keep up one's margin is to send 
in more money if at any time the change in the value of the stock 
makes the previous margin inadequate. So when the broker realizes 
on the loan he has made by selling the stock of his client he is said 
to close him out. 

Functions of Speculative Trading. — We have seen that 
speculative trading is one of the several methods by which the risk 
burden incident to all economic life is borne.^ And this risk-bearing 
naturally would be thought of as the primary function of specu- 
lative trading. A second, perhaps equally important, function is 
maintaining conditions for the determination of the right price. Let 
us now consider more carefully these two functions in detail. 

The Risk-Bearing Function Illustrated.— The way in which 

speculation carries out its primary function of assuming the burden 
of risk-hearing is best illustrated in the wheat business. As already 
remarked, it is inevitable that there should be losses unmerited and 
gains unmerited from changes in the price of any commodity from 
one part of the year to another. Further, there will be persons 
in the community who are not fit to assume this burden, although 
so situated that they will be forced to do so unless some device is 



^ From the standpoint of society at large it is a cheap and efficient 
method of bearing these risks. 



234 PRINCIPLES OF ECONOMICS [XVIII 

created whereby the burden can be unloaded. Thus, millers must 
have wheat, and they must buy it considerably in advance of the 
time when they can market the flour made from that wheat. But 
in the interim the price of wheat may fall greatly and as a result 
the price of flour will fall. The millers will therefore be liable 
to a serious loss growing out of this possible change in prices. 

It might be argued that this is only one of the inevitable burdens 
of their particular function in industrial life and so they ought to 
bear it without murmur. A very characteristic feature, however, 
of modern industrial life is extreme" specialization, — ^the working out 
of devices whereby the different burdens of productive activity can 
be separated and assigned to different agents. Now the miller has 
as his primary function the turning of wheat into flour. It is his 
performance of this service that entitles him to a living. He has no 
ambition to speculate in wheat as such, to make a living by dealing 
in this commodity so subject to changing prices. He would there- 
fore be glad to utilize some device whereby this part of the burden 
would be thrown onto someone else. 

The wheat exchange fills his need exactly. He wishes to buy, 
let us say, ten thousand bushels of wheat to be turned into flour 
in the course of the next few months. Accordingly, he gives an 
order to a broker on the Chicago exchange for that amount of cash 
wheat, that is, of wheat to be delivered at once. At the same time 
he orders the broker to sell for future delivery at the date when he 
expects to have his flour ready for the market, ten thousand bushels 
of wheat, — the price being fixed at the present moment, in relation 
to the present price of cash wheat. In the fall of the year this will 
mean a higher price for future deliveries because of the cost of 
storing, insurance and interest on the investment. Now when the 
future period comes he will get for the ten thousand bushels of 
wheat the price agreed upon anyhow. If, in order to meet this 
sale that he has made, he has to pay a higher price than was antici- 
pated, he loses on the deal, but makes a corresponding amount from 
the advance of his flour. On the other hand, if at that time he is 
able to buy in the wheat for delivery at a lower price, he gains on 
this future deal, but loses on the flour which has fallen because 
of the fall of wheat. In short, the net resultant of the whole transac- 



XVIIIl SPECULATIVE TRADING AND INSURANCE 235 

tion is that he neither gains nor loses by changes in the price of 
wheat. He is thus limited to what he calls legitimate business, the 
milling business, the turning of wheat into flour. Out of that he 
makes his living and leaves other people to speculate in wheat. It 
will contribute to a better understanding of this explanation to 
follow an imaginary transaction in detail. 

Let us suppose that our milling company sets out to supply itself 
with wheat at a time when that grain is quoted for immediate delivery 
at $1 and for future delivery at $1.04. Our problem, then, is to 
determine by experiment what the result will be when the trans- 
action is quite ended for each of the different possibilities as to the 
price actually prevailing when the future deal is consummated. 
Manifestly, these possibilities will be covered by three hypotheses: a 
price at the future date exactly equal to the expected one, $1.04; any 
price higher than the expected one, say, $1.10; and any price lower 
than $1.04, say, $.90. The three tables following give the results 
for these three hypotheses in their order. Each time the net result 
is neither gain nor loss. 

Table i 

Cash Wheat Future 

Original cost $10,000 Cost $10,400 

Storage, insurance, etc 400 



Total cost $10,400 

Value 10,400 Selling value 10,400 



Gain or loss $00,000 Gain or loss $00,000 

Table 2 

Cash Wheat Future 

Total cost $10,400 Cost $11,000 

Value 11,000 Selling value 10,400 



Gain $ 600 Loss $ 600 

Table 3 

Cash Wheat Future 

Total cost $10,400 Cost $ 9,000 

Value 9,000 Selling value 10,400 



Loss $ 1,400 Gain $ 1,400 



236 PRINCIPLES OF ECONOMICS [XVIII 

Illustrative Problems 

1. A Liverpool miller buys through a Dutch commission house 30,000 
bushels of wheat, paying 93 cents a bushel, and at the same time sells 
30,000 bushels for May delivery, the price being 95>4 cents. 

(a) Assuming that 2I/2 cents covers the cost (storage, insurance, 
and interest) of carrying the wheat from the date of purchase till May, 
show that the miller will lose nothing on the wheat even if by May the 
price should fall to 70 cents. 

(b) Would he gain if the price should rise to $1.10? Prove. 

(c) What did the word "carrying" in the second sentence of the 
problem mean? 

2. "One of the most important functions of speculation is to hasten 
the working of the processes whereby production is adjusted to fluctuat- 
ing demand." Explain how speculation does this. 

Speculation and Right Price. — We have explained the pri- 
mary, central function of speculation, the assumption of the risk 
burden of a particular type of economic activity. The second of the 
two functions mentioned above — working out a proper price — must 
be commented upon briefly. As already so often remarked, price is 
pre-eminently regulative mechanism of the present economic order. 
And we mean by right price that price which will regulate eco- 
nomic activity in accord with the demands of the situation as a 
whole. Now it is manifestly of the utmost importance that the right 
price should prevail. If there is likely to be a diminution of the 
acreage put into wheat because of the outbreak of the great war it 
is highly important that something should happen to induce countries 
unaffected by the war to increase the amount of wheat which they 
raise. But of course nothing can contribute so effectively to this 
result as an advance in the price of wheat, and that an early advance. 
But again nothing can so surely bring about this much-needed result 
as the efficient working of a great speculative market. 

In these great markets we have a large number of competing 
dealers on both sides, men of exceptional capacity, keenness, and 
knowledge, furnished with every facility for getting information 
regarding the probabilities of demand and production in all parts of 
the world. In consequence, if there is good reason to believe that 



XVIII] SPECULATIVE TRADING AND INSURANCE 237 

prices should naturally change, that the conditions of demand and 
supply will create in the near future a much higher price, that higher 
price is likely to be brought into existence much sooner, much more 
completely than without such a market. This was exactly what 
happened in the summer of 1914 at the outbreak of the Great War. 
It happened again in the summer of 19 16 when the failure of the 
new crop was in prospect, and it was just what ought to have hap- 
pened, although it was constantly misinterpreted and lamented by 
men in power who were too little informed with respect to the 
working of economic laws. The sharp advance in the price of 
wheat meant that the farmers who could produce winter wheat, 
which was to be sown in the fall of the year, would promptly im- 
prove their opportunity, would proceed to increase the acreage as 
rapidly as possible. A rise in price which had waited for months 
till after the consumer began to feel it clearly, would have been 
too late to bring the needed result. An advance in price brought 
about early, before any but the trained and well-informed speculator 
could anticipate the whole result, was just the thing which the 
situation called for. 

II 

Insurance: Its Nature and Functions 

Nature of Insurance. — The essential nature of insurance con- 
sists in the pooling, putting into one mass, of a large number of risks. 
In other words, the many persons interested act, for this particular 
purpose, as if they constituted just one person. Thus, if the indi- 
vidual owners of a thousand houses desire to insure themselves 
against loss by fire, they proceed to act in the matter as if all the 
houses were owned by them as a group. If any house burns down, 
the group replaces it by contributions raised from all members of the 
group. Otherwise the houses are treated as if owned by individuals, 
but in this respect they, are treated as if owned by the group. 

Now the function of this economic activity, this industry, if you 
please, is readily seen by considering the advantage derived from 
the practice indicated. If, in the illustration, we suppose each house 
to be worth $2,000, then without such pooling as insurance pro- 



238 PRINCIPLES OF ECONOMICS [XVIII 

vides, the burning of one of these houses would mean a total loss 
to the owner, a loss of $2,000. On the other hand, if pooling takes 
place, the result of the fire is that each owner loses $2. The ad- 
vantage of such a procedure, supposing only a few houses burn 
down, is manifest. Each owner is, indeed, obliged to lose something. 
But this amount is quite small and in exchange for it he is saved from 
the risk of losing his whole $2,000. In other words, the individual's 
advantage from insurance may be summarized as the substitution of 
a series of small, though certain, losses for the chance of a great 
loss.^ But this means that insurance makes less burdensome to 
the individual the risk incident to economic ownership. Accord- 
ingly, the function of insurance is to secure the easier bearing of 
risk. 

All Insurance Mutual. — The preceding account seemed to 
deal only with what is called mutual insurance, — insurance in which 
the parties insured are responsible for the procedure, manage the 
whole business. But most insurance, as we know, is not technically 
of this character. Instead, it is undertaken by a great corporation 
which "sells" insurance, as the agent would say, as other corpora- 
tions sell gas and electricity. Has our account covered this case? 
Surely, yes. In essence, all insurance is mutual. The fund from 
which the company makes good the losses to householders whose 
houses burn in reality comes not from the company, but from all the 
householders. If these were not making regular payments adequate to 
cover the total losses of the group, the company would have nothing 
to pay. The only difference between this case and that of strict 
mutual insurance is one of management, procedure. In the latter, 
the insured householders organize to manage the business themselves, 
accepting all the responsibilities and burdens. In the former case, 
speculative insurance it is often called, a corporate entrepreneur 
undertakes to carry out the plan, assume all the responsibilities, and 
do the necessary work. The essence of the qiatter, as before, is the 



^This surely is a social as well as individual advantage. The strain upon 
industry, the loss of efficiency due to the falling of a great loss upon a 
single individual is much greater than that of a trifling loss experienced by 
many individuals. 



XVIII] SPECULATIVE TRADING AND INSURANCE 239 

pooling of risks, the acting as one owner in respect to the burden 
of ownership. 

It should be said also that while the foregoing account of in- 
surance dealt only with loss from fire, an exactly similar analysis 
would fit the case for insurance against any type of economic loss, 
for example, cyclone, shipwreck, collision, etc. 

What Risks Insurable. — The last remark suggests that we 
need some comment on the question: Under what conditions is the 
insurance principle, the principle of pooling risks in order to diminish 
their economic burden, applicable? The answer is this: the insur- 
ance principle can be used wherever risks are fairly calculable. If 
we can prove statistically that, when any large body of losses are 
taken together, the per cent of loss is only moderately high, and 
fairly regular, insurance is feasible. Doubtless this is a somewhat 
vague rule ; but it has answered in the building up of great busi- 
nesses. With the improvements in statistical art, and the enlarge- 
ment of the pools, it has been possible to extend the operation of 
this industry more and more widely; and doubtless we have not yet 
seen the end of its development. 

Life and Endowment Insurance. — Thus far we have had in 
mind only insurance against direct loss, for example, fire insurance, 
tornado insurance, burglar insurance. But the student is aware 
that very important forms of insurance are so-called life and endow- 
ment insurance. Are these to be explained in the same way? In 
the main, yes. In one respect, however, they obviously differ from 
the cases already considered. The payments made to the insured 
or his family are not intended to cover losses incurred. They rather 
represent savings, accumulations of capital, which he has made or 
is treated as having made. The payments which the insured makes 
to the officers of the association or company — premiums — consist, 
in the cases already considered, of two parts, (i) a real insurance 
premium, his share of the losses incurred, and (2) his share of 
the costs of carrying on the business. In life or endowment in- 
surance, the major part of the payment is different from either of 
these. It is savings deposit, money accumulated and placed in the 



240 PRINCIPLES OF ECONOMICS [XVIII 

hands of the company as if it were a savings bank. The insurance 
element in his payments is so much as is needed to cover the risk 
that he will not live and save long enough to accumulate the full 
amount he has set out to save and for which he is insured. The 
insuring company or association is concerned with knowing how 
many payments he is likely to make, — which is usually the same 
as saying how many years he will live. Their statistics concern the 
average longevity of men in his class ; the statistics of the com- 
panies concerned in lire insurance concern the probable number of 
houses of certain types which will burn in a given period. 

Within the memory of people still living, not a few persons 
of intelligence and standing were wont to look on insurance, par- 
ticularly life insurance, as a form of gambling.^ What has been 
said ought to convince us of the unsoundness of this opinion. In- 
surance manifestly performs a very real service. It does easily 
and cheaply something which must be done. Risk cannot be 
eliminated from economic relations. It must be borne. Our only 
freedom of choice concerns the method of bearing it. Insurance 
is surely the best one yet devised. 

Illustrative Problems 

1. Suppose 1,000 owners of i,ooo buildings worth each $7,000 wish 
to insure themselves against fire. If the risk for the class of buildings 
involved is such that 7 out of 1,000 burn down each year, what annual 
payment from each owner would be necessary to insure all against total 
loss,— expenses of management, interest, etc., being ignored? 

2. Suppose 1,000 persons propose each to save for his family before 
his death, $2,000. All are twenty-five years of age. Knowing that any- 
one is liable to die before he has had time to save so much, they combine 
to insure one another that $2,000 shall be ready for the family even if 
death comes before that sum has been regularly accumulated. Assum- 
ing that the organization is continuous, new members joining as old ones 



' In one notable case, the spirit and even the practice of gambling has 
not been kept out of connection with legitimate insurance. This is the great 
Marine Insurance Association known as Lloyds of London. Here men are 
able to put up bets on any conceivable event without any admixture of 
necessity or social gain to make it a legitimate economic operation. 



XVIII] SPECULATIVE TRADING AND INSURANCE 241 

pass away, and, assuming the average death rate to be 18 in 1,000, what 
annual payment would each one need to make, — expenses of management, 
interest, etc., being ignored? 

3. Suppose that a certain corporation owns 500 buildings worth each 
$100,000; that to insure in an ordinary company would cost the cor- 
poration $250 a year on each building; and that the corporation is con- 
vinced that by an annual expenditure of $10,000 the fire loss can be re- 
duced to an average of one building every three years. Under these 
conditions, would it pay the corporation to insure with some company? 
Prove. 



CHAPTER XIX 

VALUE AND PRICE: PRELIMINARY 

With the present chapter we begin the study of value and 
price, a topic which, as indicated in an earher connection, consti- 
tutes the very heart of economic science. This topic will continue 
to form the subject of our study during the seven chapters follow- 
ing — in fact, it will receive much of our attention throughout the 
remainder of the text. In this chapter we shall confine ourselves 
to some preliminary topics. 

Economic Value. — The fundamental idea which in this text 
is usually attached to the phrase "Economic Value," and not in- 
frequently to the word "value" standing alone, was brought out 
in our opening chapter. Economic value is the property of having 
definitely mensurable and effective worth, the property of making 
the thing to which it attaches conduct-determining in a definitely 
mensurable fashion. As thus conceived, the word does not carry 
any suggestion of power in exchange.. From our present point of 
view, the latter property is only a manifestation of economic value 
in the more fundamental sense. Economic value, as thus under- 
stood, would be present in the economic life of a Crusoe, though 
exchange, and so exchange value, would be completely shut out by 
the circumstances of the case. For the same reason, this would 
also be the conception of economic value appropriate to a communistic 
system of economic organization. 

In our study of the present economic order, we need this deeper 
conception of economic value to help us both in getting a more 
adequate comprehension of exchange value and in supplying our- 
selves with a standard for judging whether or not the present 
system of price determination is working properly. For this second 
purpose, however, we need the broader concept of value as modified 

242 



XIX] VALUE AND PRICE: PRELIMINARY " 243 

by the adjective "real." By real value we mean the value attaching 
to things in view of all the fundamental facts of the situation, — 
momentary, accidental elements being ignored. It is the value which 
most persons would say ought to be embodied in the actual prices 
of the market, though all would agree that this result is seldom or 
never precisely attained. It may also be conceived as the value which 
the government of a communistic order would endeavor to make 
their guide in regulating the economic action of the community, in 
trying to insure that the productive resources at their disposal were 
utilized to the very best advantage. 

Valuations. — When any person comes to realize that his wel- 
fare is dependent upon the possession of particular units of any 
good, that is, when he realizes that each unit of such a good has 
effective importance for him, he inevitably comes to take a certain 
psychological attitude toward it, he prizes it or sets store by it.^ 
Further he estimates the degree to which he prizes it, the degree to 
which it seems to him important, essential to his welfare, in terms 
of some measuring unit, usually money. This process we call 
evaluation ; and the estimates themselves, we call valuations. These 
valuations, obviously, must play a very important part in the processes 
by which value or price is determined, if the desires of the persons 
who are to consume goods are to be taken into account. As we 
shall see in a later chapter, these valuations vary with the quantity 
of the commodity in question which the person interested con- 
ceives himself to have in possession; and these different valuations, 
corresponding to differences in quantity, together make up what we 
call his valuation schedule, which in turn helps to determine what 
we call his demand schedule. 

Price. — This concept of valuation brings us to another of 
very great importance in this connection, price. The valuations of 
the buyer's schedule, looked at as sums of money which he is in 
effect offering to pay for the goods in question, are prices. That 



* The property or state of being thus prized is sometimes designated 

subjective value. 



244 



PRINCIPLES OF ECONOMICS [XIX 



is, a price in this connection is a sum of money which is being 
offered for a unit of the goods under consideration. This concept, 
price, also appears when we approach the matter from the stand- 
point of those who wish to sell the commodity in question. That 
is, price includes the idea of a sum of money for which sellers 
actually offer to exchange a unit of some given commodity. Again, 
we apply the designation, price, to the sum of money which actually 
passes from buyer to seller in a specific transaction. In all these 
three cases, there is reference to an actual transaction, though in the 
first two cases, the transaction is merely contemplated, not consum- 
mated; and, in most good usage, this reference to an actual transac- 
tion, contemplated or consummated, is an essential element in the con- 
cept. For example, if, in speaking of a particular object, say a 
residence, we have in mind nothing more than what informed per- 
sons would consider its real worth, a reasonable price for it, we say 
that its value, not its price, is so and so. We speak of the price 
of that residence only when we are thinking of a figure at which 
the owner has offered to sell it, or at which someone has offered 
to buy it, or at which it has actually changed hands. 

A further mark of price is that it is concerned with a single 
conventional unit of the commodity, not with an aggregate. We 
speak of the price of a bushel of wheat ; but not of the price of 
the wheat crop of the United States. For this latter purpose, the 
term value is used, and means simply the price multiplied by the 
total number of units. 

Illustrative Problem 

It is not uncommon to find in economic textbooks the statement that 
price is exchange value expressed in terms of money. Do you suppose 
that the author of such a text would say that the annual gold product of 
the United States has a price of ninety million dollars? How would he 
probably express the fact? 

Exchange Value. — A fourth concept which seems essential 
to an adequate theory of value is exchange value. By this we mean 
the property belonging to economic goods of being able to command 
in exchange other economic goods. Though, as already remarked, 



XIX] VALUE AND PRICE: PRELIMINARY 245 

this is really no more than a special manifestation of economic 
value in the fundamental sense, under the present order it is char- 
acteristic of practically all economic goods, and, therefore, is most 
usually in our minds when we employ the word value alone. Thus, 
in interpreting the antithesis brought out under the last heading be- 
tween value and price, we ought probably to understand by value, 
not the fundamental concept explained under the phrase "economic 
value," but rather exchange value. For example, when the statisti- 
cian says that the value of the corn crop of 1900 was seven hundred 
and fifty million dollars, we understand this to mean that this sum 
was what the crop of two billion bushels would presumably have 
brought on the market, a particular price being assumed for the pur- 
pose of making this computation. 

The Scope of Value Theory, — The chief general task of value 
theory is to ascertain the causes and principles zvhich regulate value 
and price, though it is usual also to give considerable attention to 
the origin of value and price. In this text, comment on the latter 
topic is chiefly incidental. The problem of value and price de- 
termination, taken by itself, is of very broad scope, including much 
more than we can hope to cover. In fact, one might say with pro- 
priety that a really complete theory of value would consist of a 
group of theories, each devoted to the topic developed in one special 
way. For example, it would be very natural to undertake to work 
out (i) a theory of real values from the standpoint of the individual, 
(2) a theory of real values from the standpoint of society, (3) an 
abstract theory of competitive prices — prices under an order of free 
private initiative like the present one, (4) a concrete theory of 
competitive prices under the present order — prices as they actually 
work out under the present order, (5) a theory of values under 
communism, (6) a theory of prices under a socialistic order, and 
so on. 

As a matter of fact, traces of all the types of theory specifically 
named above are present in most economic treatises, though often 
probably without clear recognition by the author himself. The 
particular one of these which avowedly occupies the principal place 
in economic texts is the third, the abstract theory of competitive 



246 PRINCIPLES OF ECONOMICS [XIX 

prices, though this is usually preceded or accompanied by discus- 
sions belonging under the first theory. Incidentally, the second, 
the theory of real social values, receives some attention, particularly 
when the author is trying to pass judgment on the satis factoriness 
of the present economic order. The fourth point of view is im- 
plicit in the comments usually made with respect to discrepancies 
between the working of things as represented in the abstract theory 
of competitive prices and their actual working. In like manner, 
notions belonging to a value theory for communism or socialism 
not infrequently appear in the course of a discussion of our present 
topic. As noted above, however, the major part of the conven- 
tional treatment of our present topic belongs to the third type of 
value theory, that is, the abstract theory of competitive prices ; and 
this statement will be true of the present text. 

The Abstract Theory of Competitive Prices. — By an abstract 
theory of competitive prices, we mean a theory which confines its 
attention to a few of the majbr causes and conditions at work in 
a competitive society like ours, and, on the basis of these, works out 
a body of principles with respect to the determination of prices in 
such an order when perfectly realizing the conditions proposed. It 
should be added that this type of value theory is not only abstract, 
in that it limits our attention to a portion of the causes and con- 
ditions present ; it is also hypothetical, in that it assumes a greater 
degree of uniformity in the forces and conditions which it retains 
than actually exists in the real world. 

As already indicated, the treatment of value in the present text 
follows this conventional line. That is, the main discussion will 
be concerned with the abstract theory of competitive prices, and 
that even more completely than is usual; but matters belonging to 
other bodies of value theory will appear at various points. 

Definition of Market. — A concept quite necessary in the study 
of value or price is represented by the word "market." By this 
we mean a total constituted by a group of freely and directly com- 
peting sellers or buyers over against a coordinate group of freely 
and directly competing buyers or sellers. Here some careful ex- 



XIX] VALUE AND PRICE: PRELIMINARY 247 

planation is needed. The phrase "directly competing" in the above 
definition is intended to bring out the idea that the sellers or buyers 
of a given commodity, say, coffee, are not all members of the same 
market. Thus, the importers of coffee, the jobbers distributing it 
to retailers, the retailers selling it to consumers, though all sellers 
of coffee, do not as sellers belong to the same coffee market. The 
first belong to the coffee market constituted by themselves as sellers 
and the jobbers as buyers, — the importers' market. In turn, the job- 
bers, looked at as sellers, belong to the market constituted by them- 
selves as sellers and the retailers as buyers, — the wholesale market. 
In turn, the retailers, as sellers, belong to the market made up by 
themselves as sellers and consumers as buyers, — ^the retail market. 

The above statement must not of course be understood as deny- 
ing that the sellers in the importers' market have an influence on 
the price of coffee in the wholesale market, or that the sellers in the 
wholesale market have an influence on the price in the retail market. 
On the contrary, in each case, such influence is very great or even 
decisive. This influence, however, is only indirect, being affected 
through the buyers in the particular market under consideration, 
who in turn become sellers in the next market. Thus, jobbers, 
though not members of the retail market, influence the price in the 
market by helping to determine the price at which retailers are 
willing to sell. This way of looking at the matter explains the 
phrase in our above definition "directly competing." That is, the 
sellers or buyers who are directly competing in any particular market 
form a part of the group of sellers or the group of buyers who 
truly belong to that market. 

The preceding explanation with respect to the distinction be- 
tween the buyers or sellers of a given commodity in one market 
and the buyers or sellers of that commodity in another market, 
shows the necessity for the phrase "coordinate group" which ap- 
pears in our definition. The only proper course, surely, is to 
combine the selling group of the importers' market with the buy- 
ing group of that same market, not with the buying group of the 
wholesale market nor with that of the retail market. 

It should be noted that the above definition of market omits 
any reference to a specific place. Though a market usually has a 



248 PRINCIPLES OF ECONOMICS [XIX 

location, the really essential element in it is rather a threefold set 
of relations: (i) those among the sellers, (2) those among the 
buyers, and (3) those between the two groups over against each 
other. If men in Chicago, Detroit, and Duluth are freely competing 
zvitii each other in selling wheat to the same general group of buyers, 
they belong to the same market though located in widely separated 
cities. On the other hand, if two persons living in the same city 
and both selling coffee are after all dealing with different groups of 
buyers, they do not belong to the same market. Thus, Mr. For- 
syth, a resident of Poughkeepsie, who sells to jobbers coffee which 
he imports from Brazil, does not belong to the same market as 
Mr. Sanders, another resident of Poughkeepsie, who retails coffee 
to consumers in that city. 

Competition. — In an earlier chapter we made some reference 
to competition, defining it in a general way as the striving for the 
same prizes, the pursuit of the same opportunities, by similar units. 
It is not necessary to repeat any large part of those earlier com- 
ments ; but, in view of the fact that competition comes to a focus, 
so to speak, in the field with which we are now concerned, — ^the 
determining of prices — it seems desirable to introduce one or two 
comments here. 

Competition is between Units of Same Group. — First, let us 
once more remind ourselves of one of the most fundamental features 
of true competition, namely, that, as in all cases of true rivalry, 
the competing persons must function in the same general way. 
Buyers are competing with other buyers, not with sellers; sellers 
are competing with other sellers, not with buyers. The applicants 
for a job with the Michigan Central Railway Company are com- 
peting with one another, not with the railway company. So the 
railway company is competing, not with the applicants, but with 
other employers of such types of labor. Doubtless the successful 
applicant and the company will each try to gain some economic 
advantage at the expense of the other, — the applicant to get higher, 
the company to pay lower, wages than the market justifies. But 
this antagonistic striving is not competition. It belongs rather to 



XIX] VALUE AND PRICE : PRELIMINARY 249 

another line of action, namely, bargaining, the process through which 
seller and buyer come to an agreement. 

Involves Action of Opposite Group. — A second comment with 
respect to competition which it seems desirable to make is that, in a 
sense, full competition on the part of the persons belonging to either 
group — buyers or sellers— really involves some action on the part 
of the members of the other group. Strictly speaking, the competi- 
tion of sellers is only partial, not truly complete, unless every 
seller really gets his bid or ofifer before every buyer. So the com- 
petition of buyers is not complete, unless every buyer gets his bid 
or offer before every seller. Since the utmost effort on the part of 
sellers would never suffice to get their offers before all buyers, unless 
the latter did something to help in the process, we may say that 
competition could not be even approximately complete, unless the 
buyers contributed to the result. So, since the utmost probable effort 
on the part of buyers could scarcely suffice to get their bids before 
all sellers, unless the latter did something to help in the process, 
competition on the buyers' side could not be complete, unless 
sellers contributed in some degree to the result. In other words, 
complete competition within either group requires that there shall 
be alertness, openness of mind, and enterprise in the opposite group. 

Assumptions. — The abstract and hypothetical character of 
value theory has already been remarked. We start with a few 
assumptions respecting the causes and conditions present and respect- 
ing their uniformity of action ; and, on the basis of these assumptions, 
work out a body of doctrine with respect to the processes and 
principles by which prices are determined. Let us now give a 
moment to comment upon the assumptions which are actually em- 
ployed by the economists in connection with this task, 

A Purely Economic Individual. — We assume, first, that each 
man taking part in the exchange process is an ideal or perfect 
economic man. His feelings and motives are predominantly, if not 
wholly, concerned with getting the maximum of satisfactions for 
himself, and they consistently remain so from day to day and year 



250 PRINCIPLES OF ECONOMICS [XIX 

to year, all other motives such as charity and sympathy being shut 
out. The man has also full knowledge of market conditions and 
excellent, not to say perfect, judgment in making decisions. And 
his actions are entirely free of caprice, passion, and prejudice, so 
that he would naturally buy always in the cheapest market and sell 
in the dearest. 

A Perfect Market. — The assumption of a perfect economic 
man naturally carries with it the assumption of a perfect market 
where the man's operations are performed. In this market every 
seller is supposed to be successful in putting before every buyer 
the particular opportunity he is offering, and every buyer is sup- 
posed to be successful in putting before every seller the opportunity 
which his desire to purchase creates. In other words, perfect com- 
petition is present in such a market. The most essential features 
of such a market would be, first, extensive and efficient means of 
gaining information and disseminating it among buyers and sellers, 
and, second, conditions favorable for allowing men to act ration- 
ally on the information received. Finally, this perfect economic 
man in the perfect market is supposed to carry the principle of 
competition to its logical conclusion — to continue competing so long 
as there is a surplus of immediate economic advantage over the 
sacrifices made. 

Perfect Competition Is Not Unlimited Competition. — ^At this 
point, however, it is important to note that the perfect competition 
of economic science does not involve the idea of a competition 
which is without limits, a competition which defeats one's rivals at 
whatever the cost. It does not include such conduct as underselling 
a rival even at a loss in order to accomplish some ulterior purpose, 
for example, to punish him for a personal injury or to drive him 
out of business. The competition of economics is a competition which 
is directed to the gaining of an economic advantage derivable from 
the opportunity to make a particular sale or purchase. This means 
that, on the one hand, the seller will continue to lower his price 
until he gets for his commodity no more than it costs him (including 
a profit to himself), but no longer than this; and, on the other hand, 



XIX] VALUE AND PRICE: PRELIMINARY 251 

that the buyer will continue to raise his bid until he pays for the 
commodity as much as it is worth to him, but no longer. It is only 
on competition when understood in this sense, that the principles 
of price to be explained in the following chapters are founded. They 
assume that competition will always cease when the immediate 
economic gain is completely eliminated. Cut-throat competition, 
predatory competition, to use a term having much vogue in recent 
years, is not included in the competition of economic theory. 

Discrepancies between These Assumptions and Reality. — 

Now, as everyone knows, the ideal conditions described are never 
fully realized in any actual exchange situation. 

Men are influenced by motives other than the economic, their 
knowledge and judgment are imperfect and their actions incon- 
sistent. The perfect market, too, is rarely if ever to be found. The 
great exchanges which provide our nearest approach to it, have 
ample means of disseminating information ; but they often fall 
short in other respects, because the excitement, the rumors, the 
tendency to imitation — these and other conditions which flourish 
among a large number of men gathered in the same room — cause 
buyers and sellers to act without rationality. Moreover, we know 
that the pure competition of the economic hypothesis is only partially 
realized, being at times replaced by monopoly on the one hand or 
unbridled competition on the other. 

Legitimacy of Our Procedure. — But, although these ideal 
conditions are never entirely realized, we are compelled, if we wish 
to make any progress at all in our science, to accept them as the 
fundamental basis of our reasoning. The human intellect is of 
but limited reach and power ; and in economics, as in any other 
science, it is quite incapable of studying simultaneously all the forces 
at work, or all the varying intensities of even one force. We have 
to study the different forces separately and under simplified condi- 
tions, eliminating many elements and assuming a fictitious purity 
and uniformity in those retained. It should be added, however, 
that if this is the only way to make progress, it is in economics, 
as in other sciences, a perfectly feasible way. It enables us first 



252 



PRINCIPLES OF ECONOMICS [XIX 



to gain a knowledge of fundamental principles, uncon fused by ex- 
ceptions. When we undertake to apply the principles in actual life, 
it may be necessary again to take into account the various forces 
from which our attention has been abstracted in the purely eco- 
nomic analysis. But after all, exceptions to the principles are much 
less important than the principles themselves; and, anyway, we 
cannot even begin to understand the former until the latter come 
to hold an assured place in our minds. However abstract, there- 
fore, however dependent upon imperfect or unreal hypotheses, the 
principles constitute the deepest, most vital facts in actual price- 
determination, and so must be fully mastered. 



CHAPTER XX 

MARKET DEMAND SCHEDULES 

It is a fact with which probably everyone has some acquaintance 
that the determination of price, in any but its most superficial 
aspect, is somehow a matter of demand and supply. Accordingly, 
we must now give some attention to these elements. The present 
section will be devoted to a study of demand. 



The Nature of Deonand 

By the demand for any commodity, the economist means in 
general the quantity of that commodity which buyers stand ready 
to take at some specific price. In this definition let us emphasize, 
first, the point that demand is the amount which buyers stand ready 
to take, — offer to take. That is, demand must not be confused with 
(i) the amount men want on the one hand, nor (2) the amount 
men actually buy on the other. Demand must not be confused with 
the amount of a commodity which men zvant. Mere want, mere 
desire, not backed by buying power and not brought to an issue 
in a decision to purchase if the price is satisfactory, does not con- 
stitute demand. The penniless man looking in at the baker's window, 
however hungry, adds nothing to the demand for bread. It is 
plain, of course, that men's needs, wants and plans play a vital 
role in determining demand. Thus, if an electric company is in- 
tending to use the water-power of the Huron River on a great scale 
for supplying current to Detroit and other cities, the company will 
need a large amount of copper wire, and so will doubtless come 
on the market to buy such wire. But while needs and plans 
constitute one condition of demand, they do not constitute demand 

253 



254 PRINCIPLES OF ECONOMICS . [XX 

itself. Demand exists only when the company stands ready to buy 
the wire. 

But, if we take care not to confuse demand with the amount 
which people want or need, we must be equally careful to distinguish 
it from the amount actually bought. Demand in the correct sense 
might be characterized as potential demand ; the amount bought, 
as realised demand. Of course, the amount of the commodity in 
question which was actually bought at a certain price must have 
been the same as the amount which men stood ready to buy at 
that price, else it would not have been bought. That is, realized 
demand and potential demand at a given price must be equal. But 
the meanings of the two expressions are very different ; and this 
difference is of great importance. Potential demand, the amount of 
any commodity which men stand ready to take at each of many 
different prices plays, a very great part in determining what price will 
actually prevail. Realized demand, on the contrary, is determined 
by actual price rather than helping to determine it, 

A Conditioning Price. — A second point in our definition which 
needs emphasis is the phrase "at some specific price." Every proper 
statement affirming the existence of a demand must explicitly or 
by implication represent this demand as conditioned on a certain price. 
Thus, it is proper to say, "The demand for silver at 55 cents per 
ounce is 120,000." It is not proper to say "The demand for silver 
is 120,000 ounces," leaving out the phrase "at 55 cents per ounce," 
except on condition that both the person making the remark and the 
one to whom it is addressed already have one particular price in 
mind, as for example, the price at which sales are actually being 
made at the time the statement appears. The grounds on which 
this contention rests are perhaps sufficiently evident. The affirma- 
tion that "the demand for silver is 120,000 ounces," strictly inter- 
preted, ought to mean that there is a demand for 120,000 ounces 
of silver whatever be the price. But, of course, no such affirmation 
could reasonably be made. Everyone knows without having studied 
economics that, if the demand for silver were 120,000 ounces 
when the price was 55 cents, it would be smaller were price to 
rise to 60 cents. Accuracy, therefore, requires us to specify a price 



XX] MARKET DEMAND SCHEDULES 255 

whenever we affirm demand to be so and so ; though it is doubtless 
possible that, in any particular case, the conditioning price might 
be implied with sufficient clearness. Thus if any person familiar 
with business matters were to make a statement like the above, he 
would doubtless mean, and other persons would understand him 
to mean, that the demand for 120,000 ounces existed at the current 
market price or at some price approximately equal to the market 
price. But such carelessness of statement, trusting to mere im- 
plications, often misleads the uninformed and causes confused think- 
ing even with the trained student. 

One further point in explanation : Our definition implies that 
the relation between the volume of demand and the conditioning 
price is tzvofold. It means, first, that if price is the one named, 
the demand will be of the volume indicated, and secondly, that, 
only if price is as low as the one named, will demand be of the 
volume indicated. Accordingly, if we say that the demand for 
silver is 120,000 ounces at 55 cents, we should be understood as 
affirming both the following propositions: (a) If any person wishes 
to insure that demand shall not get as large as 120,000 ounces, he 
must insure that price does not go as low as 55 cents, (b) If any 
person wishes to insure that demand shall be as great as 120,000 
ounces, he must insure that price does go as low as 55 cents. 

Demand Price. — The point so strongly emphasized in the 
preceding paragraphs, that the appearance of a given demand is 
conditioned on the appearance of a given price, gives rise to a con- 
cept of much importance and one constantly in use, namely, that 
of "demand price." In the illustrations just used, 55 cents is as- 
sumed to be the demand price of 120,000 ounces of silver. This 
means that, if, and only if, the actual price were to become 55 cents, 
would the demand be 120,000 ounces. Further study will show us 
that at times this statement may seem to need qualification be- 
cause of the fact that demand may remain the same at several 
different prices, so that any one of these might seem to be the 
demand price, which would amount to saying that none was. It 
will become evident as we proceed, however, that, of these several 
prices, only one really conditions the appearance of the given de- 



256 PRINCIPLES OF ECONOMICS [XX 

mand, and that, therefore, only one price is really the demand price 
of the given volume of demand. 

Illustrative Problem 

"The demand for labor is almost always less than the amount offered." 
Criticize that method of statement. Remodel the statement in two 
or three different ways to show what the writer might have meant. 

II 

The Dependence of Demand on Price 

In the preceding discussion, it was shown that the quantity of 
demand is conditioned upon price. We must now explain this 

40 80 120 160 200 

1 I ' I I I I I I I I ' I ' I ' I ' I I I ' 



55- 



Figure i. Demand Dependent on Price A 

conditioning more fully. Let us suppose that, on a certain day, the 
demand for silver at a price of 55 cents is just 120,000 ounces as 
in our last illustration. This quantity is represented in the accom- 
panying diagram by the shaded rectangle, — the vertical scale at the 
left indicating the price in cents and the horizontal scale at the 
top indicating the number of ounces in thousands. The arrow at 
the left pointing from the figure 55 toward the rectangle is in- 
tended to bring out the idea that the price of 55 cents is the im- 
mediate condition or cause which insures that the demand shall 
be the amount indicated. Now, starting with this hypothesis that 
120,000 ounces are demanded at 55 cents, we may be quite sure 
that the same persons who stand ready to buy that amount at the 
price stated, or, anyhow, some other persons, are ready to buy, — 
have the mental attitude needed to induce them to buy, — say, 10,000 
ounces more at a price of 54 cents ; 40,000 ounces more at price of 
53 cents ; 80,000 ounces more at a price of 52 cents ; and so on. 
That is, right alongside of the 120,000 demand which would be 



XX] MARKET DEMAND SCHEDULES 257 

realized if a price of 55 cents were reached, and a part of the same 
general situation, we have various other potential demands which 
would just as surely be realized if lower prices were established. 
In Figure 2, we have these other demands presented along with de- 
mand at the 55-cent price. 

But, not only is it involved in the demand situation that larger 
amounts would be taken were the price lower than 55 cents; the 
complementary statement is also true. Given the present mental 
attitude of buyers, the amount demanded by them would be smaller 
if price were higher than 55 cents, instead of lower. Thus, some 



40 80 120 160 200 

I I I I I I I I I I 1 I I I I I I I I 



56 H 
55- 
54- 
53- 
52- 
51- 



Figure 2. Demand Dependent on Price — B 



of the people whose offer to buy at 55 cents aggregated 120,000 
ounces, would, if price rose to 56 cents, withdraw a part or all of 
their former demand; they, or others, would withdraw still more 
of that demand, if price rose to 57 cents; still more, if it rose to 
58 cents; and so on. That is, as a part of the same general situa- 
tion from which we set out, we have a series of potential demands 
at prices above, as well as at prices below, the assumed one of 55 
cents. Supposing these demands to be 110,000 ounces at 56 cents, 
80,000 ounces at 57 cents, 40,000 at 58 cents, and so on, and com- 
bining them with the demands indicated in our last diagram, we 
should have the result represented in Figure 3. 

The Demand Schedule. — We are now prepared to explain 
the meaning of a phrase which will be frequently used in the follow- 
ing pages, — ^the phrase "demand schedule." Demand, as we have 
just seen, is always relative to a particular price stated or implied, 



258 



PRINCIPLES OF ECONOMICS 



[XX 



and the amount of demand, generally speaking, varies inversely 
though not proportionally to price : the lower the price, the greater 
the demand ; the higher the price, the smaller the demand. It 
follows that the facts of demand at any time require for their ade- 

40 80 120 160 200 

1 I I I I I I I I I I I I I I I I I I I I I 
59- 

B8-- 

51-- 

56-- 

55 

B4-- 

53-- 

52-- 

51-] 

Figure 3. Demand Dependent on Price — C 

quate statement a series of conditional propositions. Thus, the sup- 
posed case for silver would be most adequately stated as follows : 



The demand would be 40,000 oz. 
The demand would be 80,000 oz. 
The demand would be 110,000 oz. 
The demand would be 120,000 oz. 
The demand would be 130,000 oz. 
The demand would be 160,000 oz. 
The demand would be 200,000 oz. 



if price were as low as 58 cents 
if, and only if, price were as low as 57 cents 
if, and only if, price were as low as 56 cents 
if, and only if, price were as low as 55 cents 
if, and only if, price were as low as 54 cents 
if, and only if, price were as low as S3 cents 
if, and only if, price were as low as 52 cents 



Table i 



Such a series of propositions, we call a demand schedule. In order 
to abridge the statement of it, we will put it in the form of two 
columns of figures with the proper headings. Price and Demand, 
as shown in Table i. The student must always 
remember, however, that it is, in effect, a series 
of conditional statements, such as those already 
given. 

A demand schedule of the general type just 
presented probably comes nearer to represent- 
ing the facts of experience than would a more 
symmetrical one. But as our purpose in using 



Price 


Demand 


CENTS 


000 oz. 


58 
56 


40 

80 

no 


55 


120 


54 
S3 


130 
160 


52 


200 



XX] MARKET DEMAND SCHEDULES 259 

these schedules is primarily pedagogical, we shall change this one to 
a form which can be used more effectively in clearing up the theory 
of price. In this new schedule, the variations 
of demand consequent upon changes in price Table 2 

are represented as uniform, 10,000 ounces in 
each instance. Thus altered, and carried both 
higher and lower, our schedule will appear as 
in Table 2. In diagrammatic form it is pre- 
sented in Figure 4. 



Price 


Demand 


CENTS 


000 oz. 


60 

59 
58 


70 

80 
90 


57 
56 


100 
no 


55 


120 


54 


130 


53 


140 


52 
SI 


150 
160 


SO 


170 



Real Changes in Demand. — One further 
point which should be noted before we leave 
this immediate topic is a possible ambiguity in 
our use of such expressions as "demand has 
changed," "demand has increased," "demand has diminished," etc. 
Usually we mean, perhaps always ought to mean, that the whole de- 
mand schedule has changed, — at each of the prices of the schedule, 
demand is different from what it was. Such a change is a real 
change in the demand situation and is sure to cause a change in price 
unless some other change in the conditions neutralizes this one. But 
not seldom people say that demand has changed, when they mean 
merely that another part of the existing demand schedule has been 
realised because actual price has changed and so fulfilled the con- 
dition necessary to make that part effective. Such a change is not 
really a change in demand at all. The total demand situation is 
just what it was before; since, as we have already indicated, the de- 
mand of any one moment is not just the demand at one particular 
price, but the whole series of demands at a series of prices, which 
demands and prices together embody br express the total demand 
situation. 

In order to avoid the ambiguity just referred to, it might be well 
to use the expression "the demand schedule has changed," when 
we mean that demand at the same prices has changed. As we shall 
see, a general change in the demand schedule, not in just one item 
of demand, is really necessary to bring about a change in price; 
and so this method of expression would be more adequate than any 
other. But it would probably be futile to attempt to make such 



26o 



PRINCIPLES OF ECONOMICS 



[XX 



a change in usage. We must, therefore, be careful not to confuse 
the two possible meanings of "changes in demand." 



60- 



55- 



40 



T-TT 



80 



120 



160 




Figure 4. Demand Schedule 

The Inverse Elasticity of Demand.- — Since the points estab- 
lished in the preceding discussion are of much importance in later 
connections, we will give them the emphasis derived from definite 
formulation in a principle. 

Principle — The Law of the Inverse Elasticity of 
Demand. 

Demand is always relative to a particular price ex- 
pressed or implied, and, broadly speaking, varies inversely 
as said price, though not proportionally. 

Illustrative Problem 

"The statement 'price depends on supply and demand' is not the 
whole truth; it is equally true that 'supply and demand depend on 
price.' " 



XX] MARKET DEMAND SCHEDULES 261 

Comment: The impression naturally received from the above state- 
ment — that the two propositions contrasted are really coordinate proposi- 
tions, that supply and demand on the one hand and price on the other 
are reciprocally dependent — is quite erroneous. The supply and demand 
which are dependent on price are not the supply and demand on which 
price is dependent. The latter are the supply and demand schedules, the 
total supply and demand situations of any moment; the former are the 
particular parts of a given supply or demand schedule which corre- 
spond to the different prices. An increase in supply (the supply schedule) 
will cause a fall in price, other things being equal. A fall in price, 
however, does not cause a real decrease in the supply (the supply sched- 
ule) ; it merely brings into operation a different part of the same un- 
changing supply schedule. 

Explain and defend that statement. 

Ill 
The Interpretation of Demand Schedules 

Demand Schedules Composite. — As we shall have frequent 
occasion, during our study of the theory of price, to make a dis- 
criminating use of demand schedules, it is very important that, at 
the outset, we should gain familiarity with the true nature and 
significance of these schedules and their various parts. First, it is 
to be noted that demand at any particular price is a composite made 
up of many sections or increments, each one of which, except 
the last, would appear at some higher price. To clear this up, let 
us start with the lowest line in our demand schedule on page 259, 
the demand at 50 cents. Manifestly, this 170,000 ounces consists 
of the 10,000 which came in only when price fell to 50 cents, added 
to the 160,000 already wanted at 51 cents. But the 160,000 ounces, 
in turn, consists of the 10,000 which came in at 51 cents, added 
to the 150,000 already wanted at 52 cents. And the 150,000 ounces, 
again, is the 10,000 coming in at 52 cents added to the 140,000 
wanted at 53 cents — and so we might continue all the way to the 
top of the schedule. Accordingly, the 170,000 ounces wanted at 
50 cents is the sum of all the increments of demand which would 
successively appear, if price were to pass through all stages from the 
highest to the lowest. The point just made is graphically pre- 



262 



PRINCIPLES OF ECONOMICS 



[XX 



sented in Figure 5, where the small letters represent the successive 
additions to demand which are supposed to appear at each price. 
Thus, q comes in at 50 cents itself; p came down from 51 cents; 
o, from 52 cents ; n, from 53 cents ; m, from 54 cents ; I, from 
55 cents ; and so on. 

Included and Excluded Increments. — Another important mat- 
ter concerns the different divisions into which the various sections 

40 80 120 160 



55- 



50- 



a 


b 


c 


d 


e 


f 


S 


h 


i 


3 


k 










a 


b 


c 


d 


e 


f 


g 


h 


i 


J 


k 


1 










a 


b 


Q 


d 


e 


f 


g 


h 


i 


3 


k 


1 


m 










a 


b 


c 


d 


e 


f 


g 


h 


i 


J 


k 


1 


m 


n 










a 


b 


c 


d 


e 


f 


g 


h 


i 


J 


k 


1 


m 


n 













a 


b 


c 


d 


e 


f 


g 


h 


i 


3 


k' 


1 


m 


n 





P 








a 


b 


c 


d 


e 


f 


g 


h 


i 


i 


k 


1 


m 


n 





P 


q 



Figure 5. Demand Schedules Composite 



or increments of demand group themselves when any particular 
price has been established. The first break occurs between the 
excluded increments and the included ones. Thus, if price proves to 
be 55 cents, all the increments of demand which depend upon a price 
lower than this will, of course, be shut out ; while all increments 
which depend upon this or a higher one will be included, for the 
man who was ready to buy at 56 cents or 57 cents or 58 cents will 
surely be in the same frame of mind if price falls to 55 cents. 

Marginal, Intra-Marginal, Extra-Marginal. — A still more 
useful classification of the different increments of demand takes as 
its starting point a particular one of the included increments — called 
the marginal increment — and divides all others into two groups, one 



XX] MARKET DEMAND SCHEDULES 263 

inside and one outside this marginal increment. The one chosen 
for our starting point — the marginal increment — is the last of the 
included ones, the last to appear when an actual price of 55 cents 
was being established.^ In conceiving this idea, however, we 
should not emphasize the time aspect of the matter. For it is quite 
possible that, as a matter of fact, the marginal increment came in 
earlier than some of the other included ones, though it would not 
have done so had the conditions all been what they are now. That 
is, the real point involved is that the marginal increment is the in- 
crement which, in view of all the conditions present, would be 
expected to come in last, — the one which the conditions at work 
would naturally cause to come in last. At what stage it did actually 
appear is a matter of no moment. This aspect of the case frequently 
leads the economist to substitute for this method of characterizing 
the marginal increment, one which represents it as the increment 
which would be the first to drop out if price should rise. 

Since we have chosen to designate the increment of demand 
which would naturally have come in last or would naturally go out 
first — ^that is the increment which lies at the boundary line between 
included increments and excluded ones — ^the marginal increment, 
we naturally designate all other included increments, — ^all those 
inside the marginal one — intra-marginal increments ; ^ while all ex- 
cluded ones — all outside the marginal — we call extra-marginal in- 
crements. As will appear in a later chapter, only two among all 
these various increments of demand play an immediate, direct part 
in the determination of price, namely : the marginal and first extra- 
marginal. 

The location of these various increments of demand is brought 
out in Figure 6. The rectangle opposite each price figure repre- 
sents the included demand, the demand which would appear if that 
price were established; the space beyond the rectangle included 



" It may help us to realize the true nature of this concept of marginal 
increment, as also several other very important concepts in which the marginal 
idea is present, if we think of the marginal increment as that one of the 
included increments which comes just before we are through them, just 
before we pass to the excluded ones. It is, so to speak, at the margin of 
the lake, just before we reach the shore. 

* Sometimes designated .yw/'ra-marginal. 



264 



PRINCIPLES OF ECONOMICS 



[XX 



between the dotted lines represents the excluded demand, the demand 
which at a given price would be shut out. The demand excluded 
at any price is of course made up of demands which would appear 
at lower prices. The figure opposite the 55-cent price represents 
a condition of things brought about by an actual price of 55 cents. 
40 80 120 160 

I I I 



60- 



55- 



T~rT 




50- 



Figure 6. Increments of Demand Schedule Classified — A 



The included demand is shaded as well as being bounded by the 
continuous lines; while the excluded demand is represented by the 
space between the heavy dotted lines. The square cut off from the 
right-hand end of the shaded rectangle and further marked by the 
inclosed square stands for the marginal increment of demand, the 
increment which last comes in when actual price becomes 55 cents. 
Since all demands outside this one are extra-marginal ones as well 
as excluded ones, the space between the dotted lines represents such 
extra-marginal demands. The square cut off from the left-hand 
end of this space and further distinguished by the inclosed circle 



XX] 



MARKET DEMAND SCHEDULES 



265 



represents the first extra-marginal increment of demand. This in- 
crement of demand is obviously the same as the one which would 
come in if actual price were to fall to 54 cents, that is, at 54 cents 
it would be the marginal increment of demand. It may therefore 
be represented in our diagram by the square cut off from the right- 
hand end of the 54-cent rectangle and having a small square in- 



40 



80 



120 



160 



I I I I I I I I I 



60— 



55- 



M 



50- 



Figure 7. Increments of Demand Schedule Classified — B 

scribed. Its representation in the 5 5 -cent figure, however, brings 
out better its character as extra-marginal. 



Different Demand Prices. — On page 256 it was explained 
that the particular price which was necessary to bring out any 
particular amount of demand is known as the demand price of that 
amount of demand. In the case before us, therefore, 55 cents is 
the demand price for 120,000 ounces of silver. But it is also plain 
that 55 cents is in a peculiar sense the demand price of the marginal 



266 PRINCIPLES OF ECONOMICS [XX 

increment of demand, the 10,000 ounces which would come in only 
when price fell to that point. Being thus the demand price of the 
marginal increment of demand, it is very naturally called the mar- 
ginal demand price. In like manner, 54 cents, the price which would 
be necessary to bring out the first extra-marginal increment, the 
increment which would come in only if price fell to that point, is 
naturally called the first extra-marginal demand price. 

To give our ideas with respect to these de- 
mand prices greater definiteness, it is desirable 
to deal with demand schedules in which demand 
is supposed to remain constant through several 
prices ; for such a schedule makes possible a 
sharp separation of actual price, marginal de- 
mand price, and first extra-marginal demand 
price.' A schedule of this sort is represented 
in the accompanying table and in Figure 7, — 
demand remaining just 80,000 ounces while 
actual price ranges from 59 cents down to 54 
cents, tinder this schedule, if actual price were 56 cents, the mar- 
ginal demand price would be 59 cents, since this is the price which 
brought in the last increment of demand; while the first extra- 
marginal demand price would be 53 cents, since this is the price 
necessary to bring in an extra-marginal increment of demand. Fur- 
ther, the marginal demand price would continue to be 59 cents, and 
the first extra-marginal demand price would still be 53 cents, so long 
as price was not more than 59 cents nor less than 54 cents. 

As a matter of course, we often have occasion to apply the terms 
marginal, extra-marginal, and intra-marginal to buyers. Marginal 
buyers are those who make some or all of their purchases only 
when, and because, (ictual price has fallen to the marginal demand 
price; or marginal buyers are those included buyers who would be 
the first to drop out of the market if the price should rise. In other 
words, the marginal buyers are the ones who are responsible for 



Demand 


Price 


000 oz. 


CENTS 


SO 


62 


60 


61 


70 


60 


80 


59 


80 


S8 


80 


57 


80 


56 


80 


55 


80 


54 


90 


53 


100 


52 


no 


51 



'As we shall learn in a later chapter, long-time demand schedules, — 
schedules which sum up the demand facts for a whole period — often show 
this peculiarity. 



XX] MARKET DEMAND SCHEDULES 267 

the marginal increment of demand. So, the intra-marginal buyers 
are the ones responsible for the intra-marginal increments of de- 
mand. Their purchases would be assured, even if price were higher 
than it proves to be. The extra-marginal buyers are the ones 
responsible for the extra-marginal increments of demand. They 
make no purchases and are frequently called the excluded buyers. 

Illustrative Problems 

1. Suppose that on the second Saturday of October a section of the 
demand schedule for wood in Ann Arbor is as follows : i cord wanted 
at $6 ; 2 at $5.75 ; 4 at $5.50 ; 3 more at $5.25 ; 3 more at $5 ; 7 more at 
$4.75; 8 more at $4.50; and so on. Put this into tabular form. 

2. Suppose that the conditions of demand for Milton's autographs 
are such that i would be wanted if the price were $200; 2 if price were 
$175; 4 if $150; 5 if $140; 8 if $125; 9 if $110; 
12 if $100; 13 if $90; 15 if $75; and 20 if $50. 
Put this demand schedule into tabular form. 

(If the problem had said: i wanted at $200; 
2 at $175; and so on, it would have meant the 
same thing.) 

3. Suppose that the demand schedule for sil- 
ver at a certain time is represented by the ac- 
companying table, answer the following: 

(a) Interpret the first three lines; the last five 
lines. 

(b) What would be the marginal increment 
of demand if actual price were 67 cents? 65 
cents ? 63 cents ? 59 cents ? 57 cents ? 55 cents ? 

(c) What would be the first extra-marginal increment of demand if 
actual price were 66 cents? 65 cents? 61 cents? 59 cents? 54 cents? 

(d) What would be the marginal demand price if actual price were 
67 cents? 66 cents? 63 cents? 60 cents? 56 cents? 52 cents? 

(e) What would be the first extra-marginal demand price if the 
actual price were 65 cents? 66 cents? 67 cents? 63 cents? 

(f) Who would be the marginal buyers if actual price were 66 
cents? 53 cents? 55 cents? 60 cents? 54 cents? 

(g) Who would be the first extra-marginal buyer if actual price 
were 66 cents ? 65 cents ? 61 cents ? 58 cents ? 56 cents ? 52 cents ? 



Demand 


Price 


000 oz. 


CENTS 


(^ 


68 


70 


67 


70 


66 


170 


65 


84 


64 


92 


63 


100 


62 


100 


61 


100 


60 


100 


59 


107 


58 


120 


57 


120 


56 


120 


55 


133 


54 


14s 


S3 


145 


52 


153 


51 



CHAPTER XXI 

MARKET SUPPLY SCHEDULES 

I 

The Nature of Supply 

We have considered one of the two most essential elements in 
price-determination, demand ; we must now take up the second, 
supply. In general, we shall understand the supply of any com- 
modity to mean the quantity of that commodity which sellers stand 
ready to dispose of at some specific price. 

Supply and Stock. — Here we need to emphasize, first, the 
statement that supply is the amount which sellers stand ready to dis- 
pose of. In particular, the supply of anything should not be con- 
fused either (i) with the total amount in the hands of producers 
or dealers, or (2), on the other hand, with the amount actually sold. 
Supply should not be confused with the total amount in the hands 
of producers or dealers. This total we call stock; and only a part 
of it constitutes supply, — so much of it as people stand ready to 
sell at some price or other. But, though stock is not the same as 
supply, it is of course the immediate source of supply, and, there- 
fore, does much in determining supply. On the one hand, it 
always sets an upward limit to supply. On the other hand, it exists 
only to become supply, and so must ultimately make supply as large 
as itself. The supply of wheat in the market today may be only 
10,000,000 bushels, though the stock is 1,000,000,000 bushels; but, 
in the course of the season, most of the 1,000,000,000 bushels is 
bound to be offered for sale, and, therefore, taking the season as a 
whole, the supply is certain to become substantially coincident with 
the stock.^ 



I 



' The distinction between stock and supply is more particularly applicable 
in the discussions of the next chapter. When we come to consider normal 

268 



XXI] MARKET SUPPLY SCHEDULES 269 

Again, supply must not be confused with the amount actually 
sold. The reason is analogous to that which was given to show 
that we should not confuse demand with the amount bought. As 
a matter of fact, "the amount which people stand ready to dispose 
of" may be, but need not be, equal to "the amount which is actually 
sold." But, even if the two were always quantitatively equal, the 
meaning, the connotation of the two phrases would be different. 
"The amount which sellers stand ready to dispose of" plays a very 
great part in determining price; but "the amount actually sold" is 
itself determined after price is determined. 

A Conditioning Price. — A second point in our definition 
which needs emphasis is suggested in the phrase "at some specific , 
price." No statement affirming the existence of a given volume 
of supply can be recognized as adequate unless it represents supply 
as conditional on some particular price. Thus, it is proper to say, 
"The supply of silver is 120,000 ounces at 55 cents an ounce"; but 
unless the current market price is implied and understood, it is not 
proper to say, "The supply of silver is 120,000 ounces." For the 
latter statement, literally interpreted, means that sellers stand ready 
to dispose of 120,000 ounces whether the price be low or high; 
and such a statement would in most cases be absurd indeed. 

In analogy with the case of demand, this conditioning relation 
between actual price and the volume of supply gives rise to a special 
concept of great importance, namely: that of "supply price." This 
means, of course, the particular price which is necessary to bring 
out the marginal increment of a particular volume of supply and, 
therefore, is necessary to bring out that volume as a whole. 

II 

The Dependence of Supply on Price 

Supply Schedules.— We have just seen that supply, like 
demand, is always relative to a specific price. We must now ex- 
plain this relation more precisely. First, the facts of supply, like 

price, the price which tends to prevail over some considerable period, we 
usually have to regard supply as conterminous with stock. 



270. PRINCIPLES OF ECONOMICS [XXI 

those of demand, require for their complete presentation a supply 
schedule, a series of statements giving the amount of supply at each 
of a series of prices. This follows from the fact already brought 
out that the volume of supply is always relative to price. In the 
second place, though supply is like demand in the sense that its 
volume is relative to price, the supply changes which follow 
changes in price are exactly opposite to the demand changes. 
The volume of supply increases as price rises, and diminishes as 
price falls, whereas the volume of demand, as we have seen, dimin- 
ishes as price rises and increases as price falls. In short, supply 
varies directly, though not proportionally, as price. Accordingly, the 
supply of any commodity should always be conceived as a series 
of different supplies, each one of which is conditioned on one par- 
ticular price. A series of this sort we call a supply schedule. Such 
a supply schedule for silver analogous to the demand schedule given 
on page 258 would read as follows : 

The supply would be 200,000 oz. if, and only if, price were as high as 58 cents 
The supply would be 160,000 oz. if, and only if, price were as high as 57 cents 
The supply would be 130,000 oz. if, and only if, price were as high as 56 cents 
Tbe supply would be 120,000 oz. if, and only if, price were as high as 55 cents 
The supply would be 110,000 oz. if, and only if, price were as high as 54 cents 
The supply would be 80,000 oz. if, and only if, price were as high as 53 cents 
The supply would be 40,000 oz. if price were as high as 52 cents 

As in the case of demand, we shall substitute for this schedule 
rp one better adapted to the work of explanation, 

that is, one in which the changes in volume 
consequent on changes in price are uniform. 
Such a supply schedule for silver is represented 
in Table i and in Figure i. 



Price 


Supply 


CENTS 


000 oz. 


60 


170 


59 


160 


S8 


150 


57 


140 


56 


130 


55 


120 


54 


no 


53 


100 


52 


90 


51 


80 


50 


70 



Real Changes in Supply. — The expression 
"supply has changed" shows the same fault of 
ambiguity that we found in "demand has 
changed." It ought to mean that the whole 
supply situation, the supply schedule, has 
changed. It often does mean merely that another part of the exist- 
ing supply schedule has been realised because of a change in the 
actual price. A change in supply in the former sense is sure to 



XXI] 



MARKET SUPPLY SCHEDULES 



271 



cause a change in actual price, unless neutralized by some other 
change in conditions ; a change in supply in the latter sense is caused 
by a change in actual price. 

The Direct Elasticity of Supply. — The points thus far ex- 
plained concerning the relation of supply to price, may be put into 
formal shape as follows: 

40 80 120 160 

1 1 I I I I I I I I I I 



60- 



55- 



50- 



TTT 



Figure i. Supply Schedule 



Principle — The Law of the Direct Elasticity of Supply. 

Supply is always relative to a particular price expressed 
or implied and, broadly speaking, varies directly, though not 
proportionally, as price? 



" Remember that we are now dealing with the immediate supply schedule, 
the supply schedule which is effective at any one moment. Later we shall 
have to do with long-time or normal schedules, covering a whole period of 
some length. To these latter schedules, the principle just laid down is not 
always applicable. In one set of cases, the supply may be equivalent to 
the whole stock and, therefore, does not vary at all. In another set, the 
supply is a potential output, which may be indefinitely large, provided cost 



272 



PRINCIPLES OF ECONOMICS 



[XXI 



III 

The Interpretation of Supply Schedules 

Supply Schedules Composite. — The first point to be noted 
in the interpretation of supply schedules exactly corresponds to the 
first one noted under demand schedules. The supply at any par- 
ticular price is a composite, made up of many different portions, 
each one of which, save the last, would appear at some other price, 
in this case, a lower one. Thus, the supply at 60 cents, 170,000 
ounces, consists of the 10,000 which comes on the market when, and 
because, price advances from 59 cents to 60 cents, added to the 



55- 



50- 



1 4 







8 


3 




120 

1 




160 

1 


1 1 1 


1 1 


1 1 


1 1 1 


1 


a b c |d e f | g | h | i | j | k | I 


m n 1 


Phi 










a be d e|f|g h i j|k 1 


m n 


Pi 






a|b|c |d|e| f |g|h| i| j|k| 1 


m| n 






a|b| c Idle 1 f |g|h| i| j |k| 1 


m| n 1 








abc|def|ghijkl 


m 










|a|b|c|d|e|f |g|h| i|j|k| 1 










a| b c d e 


f|g 


h|i 


j|k 





Figure 2. Supply Schedule Composite 



160,000 already offered when the price was only 59 cents; this- 
160,000, in turn, consists of the 10,000 which comes in when, and 
because, price rises from 58 cents to 59 cents added to the 150,000 
already offered at 58 cents; this 150,000, again, is the 10,000 com- 
ing in at 58 cents added to the 140,000 already offered at 57 cents; 
and so on. The facts are illustrated in Figure 2, where the little 
squares marked with small letters show the increment which supply 



of production is covered; and, hence, the schedule shows no supply at prices 
below the one covering cost and an indefinitely large supply at that cost price 
and others above it. But these points will be more fully presented later. 



XXI] 



MARKET SUPPLY SCHEDULES 



273 



receives in each instance as price rises to the level indicated. Thus, 
in the case of the 60-cent rectangle, the last increment, q, appeared 
first when the 60-cent price itself was reached; p came up from 
59 cents ; from 58 cents ; n from 57 cents ; m from 56 cents ; and 
so on. 

Different Increments. — With supply, as w^ith demand 
schedules, a second very important task is to distinguish the differ- 



40 



80 



120 



160 



60— 



55 — 



I I I 



I I I 



n 



Figure 3. Increments of Supply Schedule Classified — A 



ent divisions into which the different sections or increments group 
themselves just as soon as any particular price is established. The 
principal grouping, as before, is into included and excluded portions. 
Supposing actual price to be 55 cents, all possible increments of 
supply which are conditioned on a price of 55 cents or anything 
lower, will be included increments ; while all possible increments of 



274 PRINCIPLES OF ECONOMICS [XXI 

supply which are conditioned on a price of 56 cents or anything higher, 
will be excluded increments. Again, among the included increments, 
the most important is the marginal one, the one which is the last to 
come in when a particular price is being established. As in the case 
of demand, we should note that the marginal increment is the last 
to come in, logically not chronologically. That is, it is the one which 
the conditions present would be expected to bring in last. So, again, 
another effective way of conceiving this increment is to think of 
it as the increment of supply which would be the first to drop out 
if actual price should fall. As in the case of demand, the included 
increments other than the marginal one are designated intra-marginal 
increments; and all the excluded ones, extra-marginal increments. 
The location of these various sections of supply is plainly indicated 
in Figure 3. 

Different Supply Prices. — We have seen that, in our example, 
if actual price was 55 cents, the marginal increment of supply 
would be the 10,000 ounces coming in at 55 cents. It hardly need 
be said that this SS cents would constitute the 
iABLE 2 marginal supply price, meaning of course the 

price which is necessary to bring out, and will 
bring out, the marginal increment of supply. 
Similarly, the prices bringing out the intra- 
marginal increments of supply would be the 
intra-marginal supply prices, while the prices 
which would bring out the extra-marginal in- 
crements of supply would be the extra-marginal 
supply prices. Of these last, as in the case of 
demand prices, only one is of importance, that 
is the first extra-marginal supply price. 
As in the case of demand, the easiest way to master the dis- 
tinction between these various supply prices is to study a supply 
schedule in which supply remains constant for several steps. A 
schedule of this sort is represented in Table 2, and diagrammatically 
in Figure 4, — supply remaining at 80,000 ounces while actual price 
ranges from 54 cents up to 59 cents. Under this schedule there is 
a sharp separation between the actual price, the marginal supply 



Price 


Supply 


CENTS 


000 oz. 


62 


no 


61 


100 


60 


90 


59 


80 


58 


80 


57 


80 


56 


80 


55 


80 


54 


80 


53 


70 


52 


60 


SI 


50 



XXI] 



MARKET SUPPLY SCHEDULES 



275 



price, and the first extra-marginal supply price. If actual price 
were 56 cents, the marginal supply price would be 54 cents — the 
price which brought in the last increment of supply — and the first 
extra-marginal supply price would be 60 cents — the price necessary 
to bring in any extra-marginal increment of supply. Moreover, the 
marginal supply price would continue to be 54 cents, and the first 

extra - marginal 

40 

1 I I I I I I 



80 120 160 

I I I I I I I I I 



60— 



55- 



Q) 



supply price 
would continue 
to be 60 cents, 
so long as actual 
price was not 
lower than 54 
cents nor higher 
than 59 cents. 

Marginal 
Supply Price 
Highest. — In 

our analysis of 
demand sched- 
ules, it was 
brought out that 
the marginal in- 
crement of de- 
mand is the one 
coming in at the 
lowest of t h e 

prices at which any comes in; and so, of course, the marginal de- 
mand price is the lowest of those prices at which any demand comes 
in. The case of supply exactly reverses this. The marginal incre- 
ment of supply is that one among the several increments which 
comes in at the highest of all the prices at which any supply comes 
in ; and, so, the marginal supply price is the highest of those price's 
at which any supply comes in. 

Manifestly, similar antitheses appear in connection with the 
other significant prices. The intra-narginal demand prices are 



50- 



Figure 4. Increments of Supply Schedule Classified — B 



276 PRINCIPLES OF ECONOMICS [XXI 

higher than the marginal one ; the intra-marginal supply prices are 
lower than the marginal one. On the other hand, the extra-marginal 
demand prices are lozver than the marginal one ; the extra-marginal 
supply prices are higher than the marginal one. 

It is hardly necessary to add that we often have occasion to apply 
the terms marginal and extra-marginal to sellers. Marginal sellers 
are those who offer to sell some or all of their offerings only when, 
and because, actual price has risen to the marginal supply price. 
In other words, marginal sellers are the ones responsible for the 
marginal increments of supply. Their offerings would not be made, 
if price were lowered. Extra-marginal sellers are those responsible 
for the extra-marginal increments of supply. They, of course, 
make no sales and are commonly referred to as excluded sellers. 

Illustrative Problems 

I. Suppose the conditions of supply of Milton's autographs to be 
such that 15 would be offered if the price were $200; 13, if it were $175; 
12, if $150; 9, if $140; 8, if $125; 5, if $110; 4, 
if $100; 2, if $90; and i, if $75. 

(a) Make out this supply schedule in tabular 
form. 

(b) Make out a combined demand and sup- 
ply schedule using a demand schedule of your 
own. 

2. Suppose the supply schedule for cordwood 
on a certain Saturday to be as follows: i cord 
offered if price is $4.50; 2, if price is $4.75; two 
more, if $5; three more, if $5.25; 10 in all, if 
$5.50; 17, if $5.75; and 8 more, if $6. 

Make out a combined demand and supply sched- 
ule for this wood using a demand schedule of 
your own. 

3. Suppose that the supply schedule for silver 
at a certain date is represented by the accompanying table, and answer 
the questions which follow: 

(a) Interpret the last five lines, beginning at the last; also the tenth 
to the fifth. 

(b) What would be the marginal increment of supply if actual price 
were 55 cents? 60 cents? 63 cents? 58 cents? 52 cents? 65 cents? 



Price 


Supply 


CENTS 


000 oz. 


68 


163 


67 


150 


66 


150 


65 


142 


64 


135 


63 


120 


62 


120 


61 


120 


60 


112 


59 


100 


S8 


100 


57 


94 


56 


85 


55 


85 


54 


85 


53 


72 


52 


72 


51 


60 



XXI] MARKET SUPPLY SCHEDULES 277 

(c) What would be the first extra-marginal increment of supply if 
actual price were 54 cents ? 56 cents ? 59 cents ? 64 cents ? 67 cents ? 

(d) What would be the marginal supply price if actual price were 
67 cents ? 65 cents ? 6^ cents ? 62 cents ? 59 cents ? 55 cents ? 

(e) What would be the first extra-marginal supply price if actual 
price were 66 cents? 63 cents? 61 cents? 59 cents? 55 cents? 52 
cents ? 

(f) Who would be the marginal sellers if actual price were 67 cents? 
64 cents ? 63 cents ? 59 cents ? 56 cents ? 54 cents ? 

(g) Who would be the first extra-marginal sellers if actual price were 
66 cents? 61 cents? 59 cents? 58 cents? 55 cents? 52 cents? 

4. "In the case of a large majority of commodities, profits do not 
form a part of the marginal supply price. For, in almost every industry, 
the marginal producers, the ones whose costs determine the marginal sup- 
ply price, are getting no profit at all — in many cases are taking losses. I 
have in mind producers who are way behind the times in the methods 
they employ and hence are producing at the greatest cost of all producers 
in their line, but who are bound to stay on producing until they are bank- 
rupt just because they have no other way of making even a semblance 
of a living." 

Answer : "The producers described are intra-marginal, not marginal, 
producers." Defend the last statement. 

5. Mr, A produces a certain commodity at an actual outlay of 12 
cents per unit, while the outlay of another producer, Mr. B, is 15 cents; 
yet Mr. A may be producing the marginal increment of supply. How 
could that be true? 

6. "One of the most exasperating things in the lot of the laboring 
man is the fact that, however high-minded he may be, however anxious 
to get wages which insure himself and his family a decent living, his 
actual wages are bound to be fixed by the rate which the meanest-spirited 
of his fellow workmen stand ready to take." 

Supposing that wages were fixed by the attitude of laborers only, 
that is, by the amount which they stand ready to take, show that the par- 
ticular laborer performing this function would not be the meanest-spirited 
one. 



CHAPTER XXII 

PRINCIPLES GOVERNING THE IMMEDIATE 
PROCESSES OF PRICE DETERMINATION 

In order to make an adequate study of price, it seems almost 
indispensable to attack that problem at successive levels, in other 
words, with successive degrees of thoroughness. We shall begin, 
therefore, by trying to settle the more superficial phases of the 
problem ; follow this with a solution somewhat more thorough ; and 
finish with an attempt to penetrate the whole matter to the bot- 
tom. Our study will thus break roughly into three parts: (i) the 
immediate processes of price determination, — market price, (2) the 
intermediate processes, — normal price, and (3) the ultimate processes. 
All such divisions are of course more or less arbitrary, but the 
one used will, I believe, justify itself as we proceed. The present 
chapter, then, is concerned with the immediate processes of price 
determination. 

I 

The Law of Single Price 

From the facts of demand and supply presented in the last 
chapter, the student might naturally expect to find the same com- 
modity selling for several different prices. The appearance of a 
particular portion of demand, we learned, is conditioned on the 
establishment of one particular price, the appearance of another 
portion on the establishment of another price, and so on ; and an 
exactly similar statement is true for supply. At almost any price, 
then, buyers could find someone ready to sell, and sellers could find 
someone ready to buy. Even if the forces we are about to study 
seemed likely to set up a certain price, say 55 cents in our silver 
problem, why is it not reasonable to expect that sales would after 
all be made at both higher and lower prices? 

278 



XXII] IMMEDIATE PRICE DETERMINATION 279 

Under some circumstances, this would undoubtedly prove to be 
the case. If several buyers with different notions as to what they 
wish to pay, go to as many different sellers, and, without inquiring 
of more than one seller make their purchases, some will certainly 
pay more and some less for the same commodity. The reason is 
that each buyer is unaware of the offerings of sellers other than 
the one he has visited. Similarly, if various sellers are dealing each 
with an isolated customer, some will get larger prices and some 
will accept smaller, because each is unaware of what other customers 
might be willing to pay. Even in the same trading room it some- 
times happens that the noise, crowding, and excitement so operate 
as practically to separate the sellers and buyers into different groups, 
making sellers in one part of the room unaware of what buyers 
in another part will pay, and buyers in one part unaware of what 
sellers in another part will take. Here also, therefore, some buyers 
will pay more than they would really need to if they looked about 
them a little, and some sellers will accept less. 

But the cause of these variations is plainly something abnormal. 
The market described is not even approximately the perfect market 
which our study postulates. Full competition between the different 
sellers on the one side and the different buyers on the other is not 
realized. Some of the sellers do not have a chance to provide every 
buyer with an opportunity to purchase from them. Some of the 
buyers do not have a chance to provide every seller with an oppor- 
tunity to make a sale to them. If all sellers and all buyers did so 
provide, the result would be very different. No buyer would pay 
more than any other, because other sellers, desiring to get his custom, 
would underbid the seller about to receive the exceptionally high 
price, — would, so to speak, force the buyer to take their wares 
at the loiver price. Neither would any seller accept less than any 
other, because buyers other than the one about to get the commodity 
at the lower price would promptly overbid that one, — would, so 
to speak, force the seller to take a higher price. In a market which 
is truly single and theoretically perfect, therefore, any commodity 
at any one time must be selling at a single price. 

In the real world, of course, there are no theoretically perfect 
markets. The great exchanges for wheat, cotton, and steel where 



28o PRINCIPLES OF ECONOMICS [XXII 

many buyers and sellers actually meet in the same room and where 
almost every conceivable means is available for informing one's self 
of the facts, doubtless at times approach perfection; but ignorance, 
folly and the failure of competition always prevent the condition 
from being reached ; and in ordinary markets, naturally, this is much 
more emphatically true. Nevertheless, the tendency toward a single 
price set up by the forces mentioned above is always sufficiently 
strong to be of real and practical significance. Even in the retail 
trade, dififerences between the prices of the same commodity in the 
same market or in connected markets are at once recognized as ab- 
normal. The smallest differences are remarked upon ; anything 
like an indefinite enlargement is quite impossible ; and with the spread 
of greater knowledge, alertness, and skill among buyers and sellers 
they must tend rapidly to diminish and disappear. 

Summarizing the above discussion, we have the following prin- 
ciple : 

Principle — The Law of Single Price. 

Within the limits of a truly single and theoretically per- 
fect market, no commodity can have more than one price 
at the same time; and even within the limits of imperfect 
markets or groups of connecting markets, any commodity 
m,ust tend to have a single price, — allowance being made in 
the latter case for the expense of shifting from one to an- 
other of the connecting markets. 

Corollary i. — The law of single price secures to many 
consumers a differential advantage known as buyer's sur- 
plus, i. e., a quantity of other commodities which they can 
enjoy because of the fact that they can secure the one under 
consideration at a lower price than the price which they 
would be willing to give, even for the marginal unit. 

Corollary 2. — The law of single price secures to owners 
of some scarce and exceptionally efficient factor in produc- 
tion a differential gain. In the case of land, this is called 
rent; elsewhere, a quasi-rent. 



XXII] IMMEDIATE PRICE DETERMINATION 281 

II 

The Law of Supply and Demand 

We are now prepared to explain the actual processes of price- 
determination through what is commonly known as the law of 
supply and demand. In doing this, we shall deal with demand and 
supply schedules of the regular, symmetrical sort which we have 
called typical, though it will be necessary later to note some varia- 
tions from these. Let us begin by placing before ourselves, in 
both tabular and diagrammatic form, our typical demand and supply 
schedules combined into one. In the table, 
the common price is placed in the middle 
column, while the demands corresponding 
to the several prices appear in the first col- 
umn, and the supplies in the third. The 
diagram in the figure on page 284 repre- 
sents the supply rectangles superposed on 
those of demand in such a way that the 
boundaries of the rectangles which express 
demand and supply, respectively, at any 
particular price, coincide as far as their 

length will permit. Since the demand rectangles are shaded from 
left to right dozvnward, while the supply rectangles are shaded from 
left to right upward, the portions which coincide are cross-shaded, 
while the parts not coincident have only the parallel shading. 

Some Price Equates Supply and Demand. — From all the 
data now before us, it is easy to derive a series of propositions em- 
bodying the most important facts of immediate price-determina- 
tion. First, from the very nature of demand and supply schedules, 
there is bound to be, generally speaking, one price at which demand 
and supply are equal. This obviously grows out of the fact that 
changes in price affect demand and supply in precisely opposite 
ways: demand varies inversely as price; supply varies directly as 
price. Two quantities moving in opposite directions under the 
influence of the same cause are bound to coincide at some point. 



Demand 


Price 


Supply 


000 oz. 


CENTS 


000 oz. 


70 
80 


60 

59 


170 
160 


90 


58 


ISO 


100 
no 


57 
56 


140 
130 


120 


55 


120 


130 


54 


no 


140 


S3 


100 


150 

160 


52 

51 


go 
80 


170 


SO 


70 



282 PRINCIPLES OF ECONOMICS [XXII 

This is illustrated in the figure, in which the rectangles representing 
demand and supply coincide throughout their length at a price 
of 55 cents. 

Seeming Exception. — A seeming exception to the above 
statement might indeed be found. That is, we might have so con- 
structed our schedules that, at a price of 55 cents, supply would have 
been greater than demand; while, at 54 cents, demand would have 
been greater than supply.^ This exception, however, is only a seem- 
ing one. Under the conditions supposed, the unit of price variation 
used is too large for actual market conditions. Making that unit a 
half cent, instead of a whole one, would probably bring out a coin- 
cident price; for a fall in price from 55 to 54^^ cents, though in- 
creasing demand, would not increase it to the 120,000 which 54 
cents would bring out; while that same fall to 54>4 cents, though 
cutting down supply, would not cut it down to 110,000. In fact 
it is highly probable that, if our schedules had used this smaller 
money unit, demand and supply at this new price of 54^ cents 
would each have been just 115,000, and so the equality required 
would have been reached. If not, still further subdivision of the 
unit would have been made, until one would appear fulfilling the 
condition affirmed as necessary, that is, bringing demand and supply 
to equality. 

We have seen that, from the very nature of demand and supply 
schedules, there is bound to be a price at which demand and supply 
are equal. 

It is equally evident that, in the case of what we have called typi- 
cal schedules, any price higher than the equating one is bound to 
show a supply in excess of demand, while any lower price is bound 
to show a demand in excess of supply. This, again, grows out of 
the very nature of demand and supply schedules. As price rises, 
demand falls off while supply increases, thus making the latter ex- 
cessive. As price falls, demand increases while supply falls off, thus 
making the former excessive. 



^ Leave the supply schedule as before, but make the demand schedule read : 

60,000 at 60 cents ; 70,000 at 59 cents ; 80,000 at 58 cents ; and so on. 



XXII] IMMEDIATE PRICE DETERMINATION 283 

Sellers and Excess of Supply. — A third proposition which is 
easily estabHshed affirms that any price at which supply is in excess 
of demand is bound to be replaced by a lower price through the 
competition of sellers: any price higher than the one which equal- 
izes demand and supply is bound to be eliminated. This grows out 
of the fact that it is to the interest of all sellers who wish to make 
sales at or below the price which equalizes demand and supply to 
use every means in their power to change a condition which shows 
supply in excess, in other words, to destroy that excess. The reason 
for this is that, as long as such an excess of supply over demand is 
present, there is danger that said sellers, though willing to sell at 
a lower price will not, after all, be able to sell at all; — some seller 
who would come in only if the higher price was reached, may have 
the luck to make sales before the more willing sellers do, so that 
when the latter appear, buyers will already have been satisfied. 
But not only have the more eager sellers motives for using every 
means to eliminate the excess of supply, they have the power to do 
so. First, they are willing and so can afiford to offer the goods at 
a lower price. Secondly, this lowering of the price would reduce 
the excess of supply over demand — reduce the discrepancy between 
supply and demand, — in two ways: (i) it would increase the de- 
mand, (2) it would diminish the supply. 

This is plainly seen from the accompanying demand and supply 
schedule for silver. Sellers ready to dispose of the metal at a price 
of 55 cents cannot afford to permit a price higher than this, even 
if only one cent higher, 56 cents. For, since at 56 cents demand 
is 10,000 ounces smaller and supply 10,000 ounces larger, supply at 
this figure shows an excess over demand of 20,000 ounces, so that 
some sellers willing to supply silver at 55 cents or less may fail to 
sell at all. But, by bidding price down to 55 cents, they insure selling 
their whole supply; since they increase demand by 10,000 and 
diminish supply by an equal amount, and so make demand just 
equal to supply at 120,000 ounces. 

This reasoning is diagrammatically illustrated in the accompany- 
ing figure. At 55 cents the rectangles of demand and supply precisely 
coincide at 120,000 ounces. At 56 cents, however, supply shows an 
excess represented by the portion of this rectangle having only the 



284 



PRINCIPLES OF ECONOMICS 



[XXII 



parallel shading. Again, this excess rectangle is divided into two 
equal squares by the dotted vertical. Of these two squares, the left 
one represents that portion of the discrepancy between demand and 
supply due to the falling ofif of demand, while the right square repre- 
sents the portion of the discrepancy due to the fact that with the 
rising price supply increases. When sellers bring down the price to 

40 80 120 160 

T 



60- 



55- 



50- 




f-M. I. 

~Lm. I. 



-P. E UM. I. D. 



y, , -v^/,-. /^^vV/y^vt\ 



Price Equating Supply and Demand 



55 cents, the first portion of the discrepancy is eliminated by the in- 
crease of demand as shown in the square at the right end of the 
55-cent rectangle cut off by the dotted vertical, and the second portion 
is eliminated by the decrease in supply shown by the disappearance 
of the square which appeared at the right end of the 56-cent 
rectangle. 



Buyers and Excess of Demand. — We have seen that any 
price higher than the one which equalizes supply and demand is 
bound to be shut out by the competition of sellers. Analogous 



XXII] IMMEDIATE PRICE DETERMINATION 285 

reasoning easily shows that any price lower than the one which 
equalises supply and demand is hound to he shut out hy the com- 
petition of buyers. All such lower prices must cause demand to be 
in excess of supply. But buyers willing to pay a price as high as 
the equalizing one cannot afford to let demand remain in excess, 
lest the lower-price buyers should take off a part of the supply and 
leave them in the lurch. They — the higher-priced buyers — will 
therefore bid up the price ; and this process will eliminate the excess 
of demand and that for two reasons as before: (i) the higher price 
will increase supply and (2) the higher price will diminish demand. 
In the diagram these two sources of the discrepancy between de- 
mand and supply are represented in the 54-cent rectangle by the 
two divisions of the single-shaded portion divided by the dotted 
line. The left represents the falling-off in supply; the right repre- 
sents the increase in demand. When the actual price is bid up to 
55 cents, the increase in supply at once takes place, as indicated by 
the cross shading of the square at the right end of the rectangle; 
on the other hand, a decrease of demand takes place, as represented 
by the blank at the end of the 55-cent rectangle which takes the place 
of the last shaded square in the 54-cent rectangle. 

It is obviously implicit in the points made in the last few para- 
graphs, the points namely: that actual price cannot be either higher 
or lower than that price which equalizes demand and supply, that 
actual price cannot be different from said equalizing price. Equi- 
librium among the price-making forces could not be established as 
long as a price other than the equalizing one prevailed. 

There still remains the question whether even that equalizing 
price could prevail. Would it secure equilibrium among the price- 
making forces and therefore stand? Our answer must be in the 
affirmative. The price-making forces which are supposed to be 
operative in our problem are those which grow out of the competi- 
tion of sellers on the one hand and that of buyers on the other. 
These forces consist of that fact about the self-interest of sellers 
which leads them to underbid other sellers in order to insure getting 
a market, and that fact about the self-interest of buyers which leads 
them to overbid other buyers in order to insure getting the supply 
they desire. But just as soon as a price has been reached which 



286 PRINCIPLES OF ECONOMICS [XXII 

equalizes demand and supply, these forces become quiescent ; neither 
sellers nor buyers need to do anything in order to accomplish their 
ends. At a price of 55 cents, included sellers will market all their 
wares, included buyers will make all the purchases they desire to. 
At this point, therefore, there is no disturbing condition left, there 
is no force derived from competition which tends either to lower 
price or to raise it. This price, therefore, tends to secure equi- 
librium among the price-making forces. No other can prevail; 
this one can. Accordingly, it is the price which tends to be estab- 
lished. 

Law of Supply and Demand. — We will now summarize the 
preceding discussion in a formula which contains the most essential 
elements of what is commonly called the Law of Supply and 
Demand. 

Principle — The Law of Supply and Demand. 

Given a typical demand and supply schedule, price must 
tend to rise so long as demand is in excess of supply and 
to fall so long as supply is in excess of demand; it mitst 
therefore move up or down till it reaches a figure which 
equates supply and demand; and at this point it can rest, 
since here the price-moving forces become quiescent. 

The principle just set forth covers the main part of what is 
really essential in the law of supply and demand. Other significant 
points are little more than corollaries of this. One of the first of 
these concerns the effect on price of changes in either supply or 
demand, — meaning, remember, changes in the schedules, the different 
supplies or demands at a series of prices. As respects supply, the 
answer is contained in the following corollary : 

Corollary i. A rise or fall in the supply schedule 
tends to bring about an opposite {not proportional) change 
in price. 

A glance at the facts will show this conclusion to be inevitable. 
A rise in the supply schedule means that supply is now in excess 



XXII] IMMEDIATE PRICE DETERMINATION 287 

at the going price. But the principle tells us that price must tend to 
fall so long as supply is in excess of demand. The rise in supply 
must therefore tend to bring about a fall in price, that is, an opposite 
change. On the other hand, if the supply schedule declines in 
volume, demand at the going price, the price which made supply and 
demand equal, will be in excess of supply. But the principle tells 
us that price must tend to rise so long as demand is in excess of 
supply. A decline in the supply schedule must, therefore, tend 
to bring about a rise in price, an opposite change. 

Corollary 2. A rise or fall in the demand schedule 
tends to bring about a like (not proportional) change in 
price. 

The argument is similar to that employed for the corollary above. 
A rise in the demand schedule makes demand at the going price in 
excess of supply; under the principle, therefore, it tends to cause 
a rise in price, which constitutes a like change. A fall in the de- 
mand schedule makes supply at the going price in excess of demand ; 
and this, under the principle, tends to bring about a lower price, 
which is also a like change. 

Corollary 3. A commodity, the schedule of which 
shows a higher ratio of demand over supply at a given 
price than the schedule of another commodity shows at the 
same price, will usually show a higher actual price also. 

Thus, if at a price of 51 cents, the ratio of the demand for silver 
over the supply is 2 to i, while that of copper is 2 to 3, the price 
of silver will naturally be higher than that of copper. The price 
of silver would have to move up to equate supply and demand ; 
while that of copper would have to move down. This corollary 
emphasizes the point which the business world somewhat inexactly 
expresses in saying that "price is all a matter of the ratio between 
supply and demand." Its importance lies in the explanation it pro- 
vides of the great, and often very trying, differences in the prices 
of things, and especially in the remuneration obtainable for supplying 
different types of services. 



288 PRINCIPLES OF ECONOMICS [XXII 

Illustrative Problems 

1. "On the Black Friday of 1869, gold was sold on one side of the 
room for $1.60 when it was being sold on the other for $1.35, etc." — 
Sumner. 

(a) Why is such a fact noteworthy from the economic point of 
view? 

(b) How was it to be explained, do you suppose? 

2. Professional men, especially those of the medical profession, fre- 
quently try to eliminate the law of single price in respect to their services. 

(a) Why is it for the interest of physicians to get rid of this law? 

(b) Give some reason why they are quite likely to have more or 
less success in carrying out this policy. 

3. "The price cannot long remain above cost of production. For, so 
long as it is above, profits will be exceptionally high ; this fact will cause 
production to increase ; as a result supply will become . . . , and price 
will ..." 

Fill in the blanks, using the Law of Supply and Demand. 

4. "The demand for wheat was increased beyond the capacity of the 
best lands to furnish it, and so a new supply was brought out by putting 
inferior lands under cultivation." 

To make that reasoning quite complete, one or two other links should 
have been put in between the premise and the conclusion. Supply those 
links. 

5. "Demand having increased, price rises. But this higher price cuts 
down demand; and so price comes right back to where it was in the 
first place." 

Show that this result could not be reached in a normal case. 

6. The high rate of exchange made exporting more than usually 
profitable. As a result, the supply of cotton for the foreign market 
. . ., the price . . ., this caused the foreign demand to . . ., and so 
exports . . . 

Fill out the blanks, applying the Law of Supply and Demand. 



1 



CHAPTER XXIII 

LIMITING PRICES 

In the reasoning employed in the last chapter to establish the 
principle of supply and demand, we necessarily touched upon some 
of the deeper forces and processes which are determining prices and 
bringing them under the rule of supply and demand. We will now 
inspect these forces a little more closely. In particular, we will 
show the dependence of the prices actually established on certain 
special prices among the different demand and supply prices.^ 

The method which we employed to prove that the one price at 
which demand and supply are equal must prevail was to show that 
all other prices are certain to he shut out by the competition of either 
buyers or sellers. Actual price, we saw, must not go above 55 
cents lest it should shut out the marginal buyers, nor up to 56 cents 
lest it should let in new sellers ; and, on the other hand, it must not 
go below 55 cents lest it shut out the marginal sellers, nor down to 
54 cents lest it let in new buyers. Now, if these same facts be 
interpreted from our present standpoint, they tell us that the upper 
limits of price are fixed, or may be fixed, by either of two prices 
of the schedule, and that the lower limits are, or may be, fixed by 
either one of another two prices of the schedule. Let us now define 
more precisely these limiting prices. 

Upper Limits. — Price could not go above 55 cents lest it 
should shut out the marginal buyers. But 55 cents, as the price 
which brought in the marginal buyers, is the marginal demand price. 
It follows that actual price cannot go above the marginal demand 
price, that is, cannot go to the price next above the marginal demand 
price. Thus, one of the upper limits of price is the price next above 



'^\n later connections, we shall comment on various facts and forces lying 
behind these special demand and supply prices. 

289 



2go PRINCIPLES OF ECONOMICS [XXIII 

the marginal demand price. Again, price could not go up to 56 
cents because this would let in new sellers. But the price which 
will let in new sellers we have already defined as the first extra\- 
■marginal supply price. Consequently, actual price cannot go up to 
the first extra-marginal supply price.^ Accordingly, the second pos- 
sible upper limit of price is the first extra-marginal supply price. 

Lower Limits. — Turning now to the lower limit, price could 
not go helow 55 cents lest it shut out the marginal sellers. But 
55 cents, as the price which brought in the marginal sellers, is the 
marginal supply price. Actual price, therefore, must not go helow 
the marginal supply price, that is, as low as the price next below the 
marginal supply price. Accordingly, one of the possible lower limits 
of price is the price next helow the marginal supply price. Finally, 
price must not go down to 54 cents because that figure would let in 
new buyers. But the price which would let in new buyers we have 
already designated the first extra-marginal demand price. Hence, 
actual price must not go down to the first extra-marginal demand 
price. Thus, a second possible lower limit of actual price is the first 
extra-marginal demand price. We thus have four prices which act, 
or may act, to fix the limits within which actual price must be estab- 
lished, namely: the marginal demand price, the first extra-marginal 
supply price, the marginal supply price, and the first extra-marginal 
demand price.^ 



' In one important case, the first extra-marginal supply price and the 
marginal supply price coincide. This happens when possible output at a 
certain cost is indefinitely large: producers can supply much more than is 
demanded without incurring increased costs. In that case we cannot say 
that actual price must not go up to the first extra-marginal supply price. 
It must do so, else supply will not be adequate, since this is the marginal, 
as well as the first extra-marginal, supply price. For this case, we have to 
say that actual price cannot go beyond the first extra-marginal supply price. 
The competition of producers who stand ready to supply an indefinite amount 
at this figure will shut out any higher one. Note, however, that actual price 
cannot go above this price, not because it is the marginal supply price, but 
because it is the first extra-marginal supply price, because it is the price 
which conditions the forthcoming of more supply. 

* Remember that the marginal demand price and the marginal supply price 
are limits beyond which actual price cannot go, while the first extra-marginal 
supply price and the first extra-marginal demand price are limits to which 
actual price cannot go. 



XXIII] LIMITING PRICES 291 

In reading the above account of this matter, the student may 
object that, since both the Hmiting prices, above or below, fix the 
same price, it is hardly worth while distinguishing more than one 
of them. If actual price cannot go below 55 cents, it certainly can- 
not go down to 54 cents; if actual price cannot go above 55 cents, it 
of course cannot go up to 56 cents. This is no doubt quite true as 
applied to these perfectly symmetrical schedules which were used 
to explain the working of the law of supply and demand. We shall 
find, however, that many schedules, anyhow many supply schedules, 
are much less regular than those used. In such cases only tzvo or, 
sometimes, only one, of the four limiting prices may be actually 
operative. Our analysis, therefore, could be adequate only if it 
brought out all the limiting moments, as was done above. 

Applied to Irregular Schedules. — To clear up more com- 
pletely the matter just commented upon, let us imagine a schedule 
in which the limits set by the different moments would not coincide. 
Thus, in the accompanying table, demand remains constant at 120,000 
ounces, from 56 cents to 54 inclusive, while 
supply lemains constant at 120,000 ounces '^^^^^^^ Prick Supply 

^^ •' _ _ \ 000 OZ. CENTS 000 OZ. 

from 58 cents to 52 inclusive. Since supply 80 61 150 

and demand are equal only at three prices, ^" ^ ^4o 

56, 55, and 54 cents, the actual price must no 58 120 

be one of these. But with actual price one ^^° II ^^° 

^ 120 56 120 

of these, the marginal demand price must 120 55 120 

be 56 cents, since this is the one which j^° ^4 120 

brought in the last increment of demand ; 140 52 120 

the first extra-marginal supply price must \^ ^^ ^^ 

be 59 cents, since this would bring in the 

next increment of supply^ the marginal supply price must be 52 
cents, since this brought in the last increment of supply; and the 
first extra-marginal demand price must be 53 cents, since this would 
bring in the next increment of demand. 

But actual price, as already noted, cannot go above 56 cents, 
the marginal demand price, though as far as the first extra-marginal 
supply price is concerned, it could go to 58 cents. The latter price, 
therefore, plays no part in the final fixing of the actual price. Again, 



292 



PRINCIPLES OF ECONOMICS 



[XXIII 



D 



60 



60 



M. 



D. P. 



F. E. M. , 
D.P. 



55 



50 



iA.. p. n 



55 



F. E. M. 

<^ 

S. P. 



actual price cannot go down to 53 cents, the first extra-marginal 
demand price, though, as far as the marginal supply price affects 
the matter, it could go down to 52 cents, — supply does not begin to 
fall off till 51 cents has been reached. Plainly, then, in a case of 
this sort, two of the limiting moments of price, those which come 
from supply, are inoperative, — both the upper and lower limits of 
price being fixed by demand prices. Further, it is plain that both 

of the moments coming from 
the demand side have to be 
taken into account ; for neither 
actually fixes price, each of 
them only fixes one of the 
limits within which price may 
range. 

These points just brought 
out are presented in the ac- 
companying figure. The rect- 
angles DD' and SS' represent 
two guide posts between which 
moves a counterweight repre- 
sented by the rectangle AP. 
The guide post DD' stands for 
a series of demand prices 
from 48 cents to 62 cents ; SS' 
stands for a series of supply 
prices covering the same 
range; the counterweight AP 
stands for actual price; and the triangles projecting inward from the 
left-hand post represent the limits of price movement set by demand 
prices, while those from the right-hand post represent the limits set 
by supply prices. Since actual price must not go above the marginal 
demand price, 56 cents, it cannot go as high as the first price above 
this, 57 cents ; hence the stop block representing the limit fixed by the 
marginal demand price is set at a price of 57 cents. On the other 
hand, since actual price cannot go down to the first extra-marginal 
demand price, 53 cents, the stop block which represents the limit set 
by the first extra-marginal demand price is set at 53 cents. Turn- 



M. 



S. P. 



50 



The Four Limiting Prices 



XXIII] LIMITING PRICES 293 

ing now to the side of supply, since actual price must not go below 
the marginal supply price, 52 cents, it must not go as low as the next 
price, 51 cents ; hence the lower stop block on the supply side is set at 
51 cents. On the other hand, since actual price must not go 
as high as the first extra-marginal supply price, 59 cents, the upper 
stop block on the supply side is set at 59 cents. Manifestly, the two 
limits set by demand prices are inside those set by supply prices ; 
hence they only would be operative under this hypothesis. 

Reverse of Last. — In the schedule just used to show that 
only a part of the four limiting prices may be operative in any par- 
ticular case, supply remained constant for a longer series of prices 
than demand, and so was prevented from taking part in actual price 
determination. It is manifest that, if the hypothesis had been re- 
versed, the results also would have been reversed : the limits of price 
variation would then have been fixed by the marginal supply price 
and the first extra-marginal supply price. While buyers would 
not have permitted actual pi ice to go below the former point lest 
this should have shut out a portion of supply, sellers would not 
have permitted actual price to go up to the latter point, lest this 
should have let in a new supply. A special variation of this second 
case is of much practical importance, namely, one in which the 
two limiting supply prices, the marginal and the first extra-marginal 
ones, coincide — the price necessary to bring out a given supply and 
the one necessary to bring out the next increment of supply are 
the same. This is the case of constant-cost goods to be commented on 
later. 

Other Cases. — It is hardly necessary to add that the two 
types of schedules just used do not exhaust the possible variations 
from our original situation. Another could be imagined under the 
working of which the upper limit of price would be set by the 
marginal demand price, while the lower would be set by the marginal 
supply price. Under still another type, the upper limit would be 
set by the first extra-marginal supply price, and the lower by the 
first extra-marginal demand price. Many others beside these could 
be imagined. 



294 PRINCIPLES OF ECONOMICS [XXIII 

Summary. — In general, there are two determinants of both 
the upper and lower limits of price variation. The determinants of 
the upper limit are the marginal demand price and the first extra- 
marginal supply price : the former fixes the point above which actual 
price must not go; the latter fixes the point to which actual price 
must not go. The determinants of the lower limit are the marginal 
supply price and the first extra-marginal demand price: below the 
former actual price must not go and to the latter actual price must 
not go. 

In all cases in which the variations in the prices necessary to effect 
changes in the volume of demand or supply are considerable, only 
one of the two upper or lower determinants is likely to be effective. 

Other Demand and Supply Prices Assist. — The purpose of 
the preceding discussion was to emphasize the immediate dependence 
of actual price on one or more of just four demand and supply 
prices. To avoid possible misunderstanding, it is perhaps best to 
insert a caution at this point. In giving so decisive a place to 
certain special demand and supply prices, we do not mean that other 
demand and supply prices have no part in the matter. To establish 
any price whatever, demand and supply must come to an equality. 
With the schedule which appears on page 291, this equality of 
demand and supply was reached with each at 120,000 ounces, and 
at an actual price of 56, 55, or 54 cents. But with neither demand 
nor supply was this total brought out by the last or marginal price 
acting alone. Thus, the marginal demand price, 56 cents, con- 
tributed to this total only 10,000 ounces, 110,000 ounces coming 
down from previous, higher prices. If these earlier increments of 
demand had not come in, — if the total demand had been limited 
to the 10,000 ounces which appear at 56 cents, — equality of demand 
and supply could have been reached only at a much lower point, 
and, so, actual price would have been much lower. The whole 
demand of 120,000 ounces was necessary to make possible an actual 
price as high as 56 cents. It follows that the intra-marginal demand 
prices, the prices which were able to bring out the earlier increments 
of demand, have a part in the fixing of the actual price as truly 
as do the marginal and the first extra-marginal demand prices. 



XXIII] LIMITING PRICES 295 

The Four Occupy Key Positions. — But now we must be 
careful lest, in trying to avoid one misunderstanding, we fall into 
another equally objectionable. Although we admit that demand 
and supply prices other than the marginal and first extra-marginal 
ones share in the fixing of actual price, we by no means relinquish 
the contention that the limits of actual price are immediately de- 
termined by one or more of the four prices named. While total 
demand is obviously made up of the sum of all the increments of 
demand, these different increments must not he thought of as per- 
fectly homogeneous units entering into the total in just the same 
way. The case is not analogous to that of a pair of scales, the 
measuring pan of which is loaded w^ith several different weights 
to balance the object being weighed. In bringing down the pan, 
each of those weights acts in just the same way as every other. The 
case is quite otherwise with the different increments of demand or 
supply. While all influence the result, they function quite differently 
in doing this. The explanation is that each increment is in a very 
important sense different from every other. This difference consists 
in the fact that the emergence of any one depends on the appear- 
ance of its own special price, or one lozver, in the case of demand, 
or one higher, in the case of supply. This being true, the different 
increments cannot be treated as interconvertible, as if each played 
a like role with every other. The lowest-priced of all the demand 
increments and the highest-priced of all the supply increments hold 
key positions. Any price which will bring them out can prevail, 
even though it differs ever so much in one direction from the special 
price necessary to bring out any other increment of the total. On 
the other hand, no price which does not bring them out can prevail, 
though it brings out every other increment of either demand or sup- 
ply. In short, the immediate determination of price limits is with 
the four demand and supply prices which have been so often named ; 
the part of other demand and supply prices is to assist in determin- 
ing what prices shall occupy these key positions. 

Illustration from Analogy. — In closing this rather long dis- 
cussion, I am going to add one more illustration from analogy to the 
very considerable number which have been used by different writers 



296 PRINCIPLES OF ECONOMICS [XXIII 

in this connection. Suppose that the owner of a meat market lo- 
cated in a small town starts out to buy a dozen cattle among the 
neighboring farmers, and that he can get two from the first farm 
on his route, one from the second, three from the third, one from 
the fourth, and so on. How far will he have to go to get the whole 
twelve? Manifestly, the answer is: As far as the distance to the 
farm at u^hich he buys the last one or more necessary to make up the 
full number. In other words, the total distance to be traversed 
will depend immediately on the distance to the marginal increment, 
and, immediately, on that only. But this distance, in turn, will 
manifestly depend in part on the increments obtainable at farms 
nearer by. In consequence, these earlier increments share in de- 
termining the total distance. Their influence, however, is only in- 
direct. They help to make the total distance short or long because, 
and in so far as, they make the distance to the marginal increment 
short or long. 

Illustrative Problems 

1. The holding up of prices always depends on the bidding of in- 
cluded buyers; the holding down of prices depends on the bidding of 
included sellers. Explain the meaning of that statement and maintain 
its correctness. 

2. While the proposition laid down in the preceding problem is 
entirely sound, it is still true that the attitude of sellers has a part in 
holding up price ; while that of buyers has a part in holding down price. 
Defend that statement. 

3. Change the demand and supply schedule on page 291 so that 
the limits of price-variation would be fixed by the marginal supply 
price and the first extra-marginal supply 'price. 

4. Two conditions are really necessary to the existence of a price for 
any commodity or service : ( i ) the demand at some price above zero 
must be as great as any supply which will be forthcoming at that price, 
and (2) the demand at zero price must be greater than any supply which 
will be forthcoming at that price. Defend that statement with respect 
to both conditions. 

5. "On the other hand, if the price fell to 4 cents, the demand would 
exceed the supply by 500 pounds, and those demanding this extra amount 



XXIII] LIMITING PRICES 297 

would be unable to get it except by bidding a higher price, and so their 
competition would drive price up." Criticize. 

6. "On account of the very weak bargaining power of the laborer, 
there is nothing to hinder the rate of wages from going down to the 
lowest amount laborers can be induced to take." Criticize. 

7. "Five persons from a shipwrecked steamer are temporarily saved 
by getting on a raft ; a sixth climbs on, and the raft sinks. Obviously it 
was not just the sixth person who sank the raft, but all the six persons. 

' No more do the marginal and first extra-marginal demand and supply 
prices by themselves fix actual price. All the demand and supply prices 
equally share in the process." 
Show that the analogy is false. 



CHAPTER XXIV 

NORMAL DEMAND SCHEDULES 

At the beginning of the lasi cnapter, it was explained that our * 
study of price-determination was to be divided into three parts 
according as it was concerned with the immediate, the intermediate, 
or the ultimate stages of price-determination. The first of these 
stages has already been covered. In the present chapter, we begin 
our study of the second. 

Need for Normal Price Theory. — ^The necessity for a separate 
treatment of these two stages can be made clear by means of an 
illustration. In the early nineties of the last century the bicycle, 
which had just recently been invented, was in process of evolution. 
At that time, the price of any machine likely to prove serviceable 
to the buyer was in the neighborhood of $ioo to $125. That this 
price was more or less fully the result of the natural working of 
the laws of price which were considered in our last chapter, there 
can be no question ; at any rate it was doubtless one which brought 
demand and supply into approximate equality. However, the price 
was believed by all well-informed persons to be something quite 
temporary in character. Prospective buyers with lean pocket-books 
or with more than the usual amount of prudence and patience con- 
fidently expected and waited for a decided fall. "The present 
price," said they, "is plainly abnormal. Doubtless for the time being 
various causes may enable producers to hold the price up to $100; 
but this cannot last many years." 

Here we find implied the chief reason for distinguishing between 
the study of the immediate processes of price-determination which 
occupied the last two chapters and the study of deeper processes 
which begins in this. Behind the price temporarily prevailing under 
the influence of immediate forces, there is a price which tends to be 

298 



XXIV] NORMAL DEMAND SCHEDULES 2<^ 

established by the more permanent forces and toward which the 
actual price is constantly being driven. And this other price, which 
we call the "normal," is in the long run of far greater significance 
than the one established by immediate forces. Three chapters will 
therefore be given to the study of normal price ; this chapter and the 
next to preliminary matters, and the last to the actual processes of 
normal price-determination. 

Meaning of Normal Price. — While the meaning of the phrase 
"normal price" is indicated in the last paragraph, an additional 
comment or two may serve to make it clearer. It means a price 
■which is always tending to prevail during a given period as a result 
of the action of those forces which operate throughout the period, 
especially the larger of those forces. But, though always tending to 
prevail, we should note that, because of the interference of tempo- 
rary forces, normal price seldom if ever does prevail; and for this 
reason it is often defined as the price toward which actual price 
constantly gravitates, or about which actual price constantly oscil- 
lates. Again, normal price should not be confused with average 
price, which is a mere arithmetic concept. The two might coincide 
quantitatively, though it is probable that they seldom do. In any 
case, they differ radically in meaning or connotation; and, if a 
certain price were at once the average of all actual prices for a 
given period and the price tending to be established by the permanent 
forces of that period, we should call it a normal price solely because 
it fulfilled the second condition. 

Supply and Demand Not Superseded. — One of the first mat- 
ters to be emphasized in connection with normal price is that the law 
of supply and demand already presented still governs the immediate 
processes of price determination. In creating a tendency for some 
particular price to prevail, the permanent forces necessarily operate 
through, and only through, their power to influence the immediate 
demand or supply schedule. Thus, if certain forces tend to estab- 
lish a normal price of 30 cents for wooden chairs, they do this 
simply because they have the power so to influence the supply 
schedule that every time the price goes above or below 30 cents, a 



300 PRINCIPLES OF ECONOMICS [XXIV 

tendency is established to pull it back to that point under the natural 
working of the Law of Supply and Deiuand. 

But the law of supply and demand dominates normal price in 
a deeper sense. Besides the immediate demand and supply schedules 
which at any moment prevail there are long-time or normal demand 
schedules and long-time or normal supply schedules covering the 
whole period under consideration. Thus, when the immediate de- 
mand schedule for silver on a particular day in 19 18 was 20,000 
ounces, if price were 60 cents; 22,000, if 59; 25,000, if 58; — ^there 
must also have been a schedule for the whole year 1918, a schedule 
which might have read something like this : 260,000,000 ounces 
wanted if price were 60 cents; 275,000,000, if it were 59; 290,- 
000,000, if 58. Similarly, alongside the immediate supply schedule 
there must also have been a long-time supply schedule on a much 
larger scale. 

Now the price which is tending to be established all through this 
period — ^the normal price, — is determined by the relation between 
these long-time or normal demand and supply schedules. Thus, 
suppose that the schedules for silver given on page 281 represent 
the long-time supply and demand conditions for that metal, rather 
than the immediate ones. Then the price which these schedules 
would naturally establish, 55 cents, would tend to be the normal 
price for the whole period, one year ; just as, in the example given, 
it tended to be the market price for the single day when those 
schedules were effective. With these long-time schedules, as with 
the market schedules, there would be one and only one price at which 
demand and supply were equal ; and, under the normal working 
of economic forces, this one price would tend to be established. In 
undertaking our deeper study of price, therefore, we are not leaving 
behind the law of supply and demand, but merely bringing out forces 
and processes which lie a little deeper. In fact, all our later ex- 
position of the theory of price will, in a sense, do little more than 
elaborate and complete our account of the principles of supply and 
demand. 

Normal Demand Schedules. — We have seen that the deeper 
forces determining normal price necessarily act through suppl)' and 



XXIV] NORMAL DEMAND SCHEDULES 301 

demand, — long-time supply and long-time demand ; so that behind 
normal price we find normal supply and demand schedules, just 
as behind market price we find market supply and demand schedules. 
The remainder of this chapter will be devoted to normal demand 
schedules. 

Begin with Individual Schedules. — In analyzing normal de- 
mand schedules, our first need is to consider the deeper factor or 
element which lies behind demand prices. What determines the 
prices which in the long run buyers stand ready to pay for a given 
quantity of goods? In answering this question, it is necessary that 
we should go to the schedule of the individual buyer and ask 
ourselves what motive or motives finally determine his conduct. For, 
obviously, the general or social schedules with which we have to 
deal are composites or aggregates of numerous individual schedules. 
Thus, when we say that, according to the general demand schedule 
for silver, 180,000,000 ounces are wanted if price is 55 cents, we 
mean that the different amounts of demand at 55 cents from the 
schedules of all the different buyers of silver will, when added to- 
gether, give a sum of 180,000,000 ounces. 

The student should not, of course, be misled by this emphasis 
upon the priority of individual schedules over the general market 
schedule, into thinking those individual demand schedules are made 
up independently of social forces. The wants of any individual, and, 
therefore, the valuations which he puts upon goods, are necessarily 
in a very great measure the creation of the community in which he 
lives, just because his standards, ideals, and tastes are in great meas- 
ure the creation of that community. We are born into the family, 
into society, into the state; and our ideals are never formed inde- 
pendently of these groups. But this admission does not at all conflict 
with our doctrine that the demand schedules of the market are com- 
posites, made up by adding together the demand schedules of indi- 
viduals. For, however large may be the share of social forces in 
the determination of our wants, tJiose forces finally express them- 
selves through the demand of individual men. Goods are purchased 
not by the group will, nor by the group ideal, but by concrete and 
separate persons. We proceed, therefore, to consider the normal 



302 PRINCIPLES OF ECONOMICS [XXIV 

demand schedules of the individual. Here our chief task is to study 
the principles which regulate individual demand prices and the forces 
lying behind them. 

Demand Price and Marginal Valuation. — First, let us remind 
ourselves that each demand price appearing in the schedule of the 
individual is the price which is necessary to induce him to purchase 
the corresponding quantity of the goods in question. But, secondly, 
we must remember that the price in question was necessary only in 
the case of the last increment of the total amount involved. For 
earlier increments of that total the prospective buyer would have been 
willing to pay higher prices. Immediately, then, his demand price 
for a given total is really his demand price for the last increment of 
that total. 

It follows, therefore, that, in tracing causation in the 
case of demand prices, we have to follow the history of the mar- 
ginal demand price. Accordingly, what is the immediate cause 
which makes the prospective buyer's marginal demand price what 
it is? 

Surely the answer is that such cause is the valuation which the 
buyer puts on that last increment. He puts that price on the volume 
of demand of which this is the last increment, because he esteems 
such last increment that much — sets that much store by its possession. 
Thus, if his schedule for apples reads as follows: one peck wanted if 
price is $2.00; two if price is $1.50; three if price is $1.25; and so 
on, this shows that he values a single peck at $2.00 ; a second at $1.50 ; 
a third at $1.25 ; and so on. 

Valuation Based on Significance. — But, again, these valua- 
tions of the prospective customer must have something behind them. 
There must be a reason for valuing the apples in our illustration. 
That reason, immediately speaking, is the fact that the apples have 
significance or importance for the welfare of the prospective custom- 
er, and the further fact that he realises that they have such signifi- 
cance. Because of these facts he attaches value to the apples and 
gives measurement to that value in terms of a common measure, 
usually money. In short, the valuations of the customer are his 



XXIV] NORMAL DEMAND SCHEDULES 303 

estimates of the significance or importance to himself of the several 
increments of apples or whatever good is in question.^ 

It is hardly necessary to say that these valuations, these estimates 
by the individual of the significance of particular increments of goods, 
lack the precision which would be required in most other measure- 
ments of a scientific character. Nevertheless, these estimates are 
very real and sufficiently precise for the purposes of economic life, 
as is abundantly proved by the fact that, if in view of all the circum- 
stances the price seems reasonable, our buyer actually decides in 
favor of the apples rather than using his money to buy something 
else. 

Significance Based on Utility. — We have seen that the de- 
mand prices of buyers grow out of the valuations which those buyers 
put on the goods, and that these, in turn, grow out of the significance 
or importance to said buyer of the goods in question. But, plainly, 
we are not yet at the bottom of the matter. Why do goods have 
significance to the individual, and what determines the degree of their 
significance? The immediate, and from the economist's standpoint, 
the ultimate ground of signficance or importance in any commodity 
or service is the utility of that commodity or service, its capacity 
to satisfy wants, to make some contribution to our welfare. Because 
things can bring us advantage, they have significance or importance 
for us ; having such significance, we value them ; because they are 
valued by us, we stand ready to give a price for them. Our demand 
prices for things, therefore, are the final result of a series of causes 
beginning with utility? 



^ Remember that these are the valuations of the individual interested, not 
those of some absolute intelligence outside himself nor those of society as a 
whole. How far they are of interest from the standpoint of society at large 
will have to be considered in later connections. 

^The above account of the causes, forces, lying behind, and determining 
demand schedules confines its attention to the demand schedules of con- 
sumers in the strict sense, that is, persons who wish to buy the commodity 
in question as a means of satisfying some want, though some portion of the 
demand for the same commodity often comes from producers, while the 
demand for some types of goods comes almost entirely from producers. 
It can scarcely be doubted, however, that, indirectly and in the long run, 
the attitude of consumers must be decisive in determining that of producers, 
else the latter would find themselves bankrupt. The processes by which 
this result is reached are necessarily obscure ; but some notion of theii 
character will be brought out in Chapters XXIX and XXX. 



304 PRINCIPLES OF ECONOMICS [XXIV 

Diminishing Marginal Utility. — Our analysis has brought us 
to utility as lying behind and determining the significance of products 
to buyers, just as these lie behind and determine the valuations of 
buyers, just as these, in turn, lie behind and determine the demand 
prices of buyers. From the standpoint of the economist, this brings 
us very near the end of the matter. It might indeed be argued that, 
since utility is the capacity to satisfy wants, we ought now to under- 
take a careful study of the nature and origin of wants and the pe- 
culiarities or qualities of things which fit them to satisfy those 
wants. As a matter of fact, we mostly leave these things to investi- 
gators in other fields. In the present connection, anyhow, we shall 
confine ourselves to a single fact about wants, and that a fact which 
is so familiar to everyone that, when understood, it is at once ac- 
cepted. That fact is that, in most cases, the process by which a want 
is satisfied to the point of satiation is one which may be characterized 
as a declining progression. That is, said satisfaction has to take 
place in successive stages and the addition to gratification derived 
from the addition of a unit of commodity is each time less than 
proportional. Thus, if one were quite hungry, a single slice of 
bread would give very great gratification ; a second would give some- 
what less ; a third decidedly less ; and so on ; till satiation was reached.^ 
It follows that the gratification derivable from the last unit of a given 
quantity of any commodity is bound to be smaller than that derivable 
from the last unit of a smaller quantity of that commodity. But, in 
view of our use of the word "marginal" in other connections, we 
naturally designate the gratification derivable from the last unit of 
a given quantity of any commodity the "marginal" gratification. 
Hence we say that the marginal gratification derivable from a given 
quantity of any commodity diminishes as the quantity of that com- 
modity consumed increases. But it is, of course, implicit in this 
statement that the power of marginal units of any commodity to give 
gratification diminishes as the quantity in possession increases. Fur- 
ther, the power of a commodity to give gratification we call its utility. 
Hence we have the following principle : 



^ Doubtless this account of the matter does not apply to all cases ; but it 
is of sufficiently general application to be of great importance. 



XXIV] NORMAL DEMAND SCHEDULES 305 

Principle — The Principle of Diminishing Marginal Utility. 

The marginal utility of any economic good varies in- 
versely as the quatitity at disposal. 

Diminishing Effective Significance. — Since, as we saw above, 
the utility of any commodity is the source from which its significance 
or importance is derived, it follows that, if the marginal utility of a 
given commodity diminishes as the quantity at disposal increases, the 
marginal significance of such a commodity must also diminish in the 
same way. But we can go further. Not only does the marginal 
significance of such a commodity diminish with its quantity, the 
effective significance of every unit of that quantity also has the same 
experience. That is, its efifective significance cannot be greater than 
the significance of the marginal unit. The true importance of any 
commodity is determined by the loss which we should experience if 
deprived of a unit of that commodity. But, since different units of 
commodity are interchangeable, it is quite certain that, if deprived of 
a particular unit, we would not permit ourselves to be deprived of 
one of the higher gratifications to be derived from such a unit of 
that commodity. Instead, we should relinquish the lowest gratifica- 
tion of all, withdrawing, if necessary, the unit formerly put to the 
marginal use from that marginal use and devoting it to the higher 
service which had formerly been cared for by the lost unit. In short, 
the effective significance of any commodity varies inversely as the 
quantity of that commodity at our disposal. 

Diminishing Valuation. — Having now reached the conclusion 
that the significance of a commodity varies inversely as the quantity 
in possession, we inevitably take another step and recognize the ex- 
istence of a similar law for valuation. Since the effective significance 
or importance of a commodity diminishes with the quantity at our 
disposal, it necessarily follows that our valuation of such a com- 
modity takes the same course. If a unit of a given commodity has 
less effective importance than hitherto because I have at my disposal 
a larger quantity, and my want schedule for that commodity has not 
altered, I will naturally evaluate that commodity at a lower figure. 



3o6 PRINCIPLES OF ECONOMICS [XXIV 

That is, the consumer's valuation of a commodity varies inversely 
as the quantity at his disposal or that conceived to be at his dis- 
posal. 

Diminishing Demand Prices. — We come, finally, to the de- 
mand prices of the consumer. These surely must take the same 
course as has his valuation. That is, when he is contemplating the 
purchase of a certain number of units of a commodity, the price 
upon which will be conditioned his taking that quantity will depend 
on the valuation which he has put upon said quantity. His demand 
prices, therefore, will take the same course as his valuations. That 
is, the demand prices of a prospective buyer vary inversely as the 
quantity of the commodity which he conceives himself to be pur- 
chasing. 

These analogous propositions with respect to valuations and 
demand prices are illustrated in the diagram of Figure i. Valua- 
tions or prices are measured vertically on the line at the left, while 
the quantity of the commodity supposed to be in possession, actual 
or contemplated, is measured along the horizontal line at the base. 
The heavy verticals side by side indicate the valuation or demand 
price attached to the particular quantity of the commodity which is 
measured by the distance from zero to the point where the vertical 
is erected. The commodity under consideration is supposed to be 
sugar, the unity of quantity 5 pounds, and that of valuation or price 
5 cents. Thus if the quantity be 5 pounds, its valuation or demand 
price will be indicated by the tallest vertical at the left, that is, will 
be 100 cents; if the quantity be 10 pounds its valuation or demand 
price will be represented by the second vertical, that is, will be 65 
cents ; and so on. The line of causation, — the fact that in this prin- 
ciple the quantity of the commodity is the condition and the utility 
or significance or valuation or demand price the consequence, — is 
indicated by the vertical arrows starting from the base line on which 
quantity is measured. As required by our principles, the verticals 
representing valuations or demand price grow shorter with every 
increase in the quantity assumed, being, for example, 75 cents for 
30 pounds; 45 cents for 60 pounds; 30 cents for 75 pounds; and 
so on. 



XXIV] 



NORMAL DEMAND SCHEDULES 



307 



Inverse Elasticity of Demand. — Very little reflection should 
be necessary to convince the student that, in the principle just brought 
out, we have, in part anyhow, the explanation of the principle of 
the Inverse Elasticity of Demand discussed in Chapter XX. Since 
the consumer's valuation and demand price for the first 5 pounds of 
sugar is $1.00, it necessarily follows that an actual price of $1.00 



100- 



75- 



50- 



25- 



llh 



1 1 1 1 ! 1 1 1 1 1 1 1 1 1 1 1 f 1 1 t 
I I I I I I I I I I I I I i I I I I I I I I 

25 50 75 100 

Figure i. Utility, Valuation, and Demand Price Schedule 



will make his demand 5 pounds. Similarly, since his demand price 
for a second unit is 95 cents, an actual price of 95 cents will make 
his demand 10 pounds; since his demand price for 15 pounds is 
90 cents, an actual price of 90 cents will make his demand 15 
pounds; and so on. This is brought out in Figure 2, which shows 
the particular quantity of demand resulting from each actual price. 
In this diagram, therefore, the arrows start from the price scale and 
run from left to right. A i -dollar price results in a 5-pound de- 



3o8 



PRINCIPLES OF ECONOMICS v 



[XXIV 



mand ; a 95-cent price results in a lo-pound demand ; a 90-cent price 
results in a 15 -pound demand; and so on. 

Social Demand Schedules. — Thus far we have considered 
only the demand schedule of the individual. But, obviously, the 
demand schedule which plays a decided role in the general market 



100- 



75' 



50- 



25- 



□ 



1 1 




1 1 




1 1 




















Z3 








1 






1 












1 


























1 










1 
















1 








1 


































=1 








1 








1 








1 








1 










1 1 1 1 


1 1 1 1 


1 1 1 1 


i 1 1 1 



25 50 75 100 

Figure 2. Demand Schedule Resulting from Valuation Schedule in Figure i 

is the social or general schedule. Hence we must bring our discussion 
to a focus in the general or social demand schedule. 

Inverse Elasticity of Social Demand. — Here the chief thing 
to be noted is that the general schedule shows just the same relation 
to valuation and demand price schedules, as did the individual de- 
mand schedule. That is, the general demand schedule results from 
the general valuation and demand price schedule. Thus, the demand 
schedule represented by the figure on page 260 results from a 
marginal valuation or demand price schedule analogous to the one 



XXIV] 



NORMAL DEMAND SCHEDULES 



309 



considered above. Such a schedule for silver is represented in 
Figure 3. According- to this diagram, a stock of 70,000 ounces has 
a marginal valuation and so a demand price of 60 cents ; one of 80,000 
has a marginal valuation and so a demand price of 59 cents ; and so 
on. And it is because of these facts that the results in respect to 



60 



55- 



50- 



t t t 




t t t 1 t 



40 



80 



120 



160 



Figure 3. Utility, Valuation, and Demand Price Schedule Producing 

Demand Schedule 

demand which appear on page 260 emerge. Thus, since 70,000 
ounces have a demand price of 60 cents, therefore an actual price of 
60 cents will bring out a demand of 70,000 ounces. Since 80,000 
ounces have a demand price of 59 cents, therefore an actual price of 
59 cents will bring out a demand of 80,000 ounces ; and so on. 



Most Social Demand Schedules Elastic. — I will now close 
this discussion of normal demand schedules with a statement regard- 
ing their general character. Generally speaking, all normal demand 
schedules ore of the kind which in the chapters on Immediate Price 



3IO PRINCIPLES OF ECONOMICS [XXIV 

Determination were characterized as typical. Doubtless this must 
be affirmed less roundly of some than of others. A few are relatively 
inelastic, for example, those of the prime necessaries of life; but, 
over a wide range of prices, most schedules show fairly uniform 
changes in demand with every material change in price. This fact, 
as we may easily see, is quite inevitable. ( i ) General schedules are 
composites of numberless individual schedules. (2) The tastes and 
wants of individuals differ greatly. (3) Most of all, the incomes of 
individuals are very unequal. As a result, there will be some effective 
demand at almost every price level. Even at very high levels, those 
who are rich and wish a commodity intensely will continue to demand 
it ; while, with each fall in price, some persons who care less or have 
smaller incomes or who fulfil both these conditions will come in 
with a new demand. The general schedule, as a whole, therefore, 
will show a high degree of continuity, regularity, and symmetry. 

Illustrative Problems 

1. "The common teaching of economists that the normal price of 
products equals cost of production is entirely untenable. Normal price 
of course means the price which usually prevails. But, now, every one 
knows that the price of any product rarely, if ever, coincides with its cost 
of production. Hence a price which actually did coincide with cost 
would be an abnormal rather than a normal one." 

The above quotation may furnish a valid reason for choosing some 
word other than "normal" to designate what the economist has in mind ; 
but it does not furnish a valid argument against the doctrine that the 
normal price of the economist coincides with cost. Explain. 

2. "All talk about normal price is simply silly. There isn't any such 
thing. The economist teaches that normal price corresponds to cost of 
production ; whereas every one knows that, during the last two or three 
years (written in 1918), the prices of almost all commodities have been 
far above cost of production." 

Is his denial of the existence of normal price reasonable? Explain. 

3. One of the possible upper limits of the actual price of any com- 
modity is its marginal utility or significance ; while one of the possible 
lower limits of that price is the first extra-marginal utility or significance 
of said commodity. 

Give the argument needed to support those propositions. 



CHAPTER XXV 

NORMAL SUPPLY SCHEDULES 

In the preceding chapter we considered various topics prelim- 
inary to the study of normal price, including normal demand sched- 
ules. In this chapter we continue the study of preliminaries, 
especially matters connected with supply. 

Market Supply Schedules. — The supply schedule with which 
we were concerned in our first study of the processes of price- 
determination is most naturally designated the market supply sched- 
ule. In that schedule we are looking at the immediate attitude of 
sellers. At a certain time, for a great variety of reasons, sellers are 
ready to sell a certain number of units of a commodity if price is 
so and so, another number if price is something else, and so on. This 
attitude of sellers is a momentary one, — an ever-changing one. If 
they hear a little different news as to conditions in other markets, 
the probabilities of demand in some other community, or the success 
of production during the current season, they will alter their supply 
schedule, will change the quantity they are willing to sell at any 
particular price. 

Normal Supply Schedules. — We wish now on the other hand 
to study the attitude of sellers throughout a longer period. During 
a season, a year, or a series of years, sellers are acted upon by certain 
larger and more permanent forces, and under the influence of those 
forces, they stand ready to sell a particular number of units of a 
commodity if price is so and so, another number if price is some- 
thing else, and so on. This attitude of sellers is represented in the 
normal or long-time supply schedules. As a final preliminary to our 
study of actual normal price and its determination, we must now 
investigate the nature of these normal supply schedules. 

311 



312 PRINCIPLES OF ECONOMICS [XXV 

Different Classes of Goods. — In undertaking this task, our 
first step is to note some fundamental differences among goods, since 
these differences are responsible for marked differences in the normal 
supply schedules of such goods. The most important of these dif- 
ferences gives rise to two main classes of goods : ( i ) those goods the 
stock or output of which is increasable — producible goods — and 
(2) those of which the stock or output is fixed. The first obviously 
includes the great majority of commodities in everyday use, food, 
shelter, clothing, etc. The second class includes a few objects of 
direct use in the satisfaction of wants, for example, the paintings 
of an artist now dead ; but it mostly consists of certain primary fac- 
tors in production derived from nature, for example, ultimate or 
primary raw materials such as iron and copper, the services of land, 
and water powers. The former of these two classes again divides 
for our purpose into two sub-classes : increasing-cost and constant- 
cost goods. Accordingly, we shall study more or less fully the supply 
schedules of three types of goods: (i) Increasing-Cost Goods; 
(2) Constant-Cost Goods; and (3) Fixed-Supply Goods. 



Costs and Supply Prices 

The most obvious, as also the most important, fact about the 
normal supply schedules of producible goods is that the supply prices 
of such a schedule, that is, the prices on which depends the forth- 
coming of supply, are fixed by costs of production, including, of 
course, suitable remuneration for such contributions as are made by 
the entrepreneur himself. If a certain price will insure to the 
entrepreneur that he will get back the money he has put into a 
product and in addition will get a reasonable return for his own 
direct contributions, he will surely be ready to furnish the product 
at that price. Doubtless he would be glad to get a higher price ; and, 
under some conditions, he may be able to do so. But that fact has 
no relation to our present problem, which is concerned solely with 
the normal supply schedule — the series of mutually dependent sup- 
plies and prices. What price will be necessary to secure the forth- 
coming of a given supply? or what volume of supply will follow 



XXV] NORMAL SUPPLY SCHEDULES 313 

the appearance of a given price?— these are the questions of immedi- 
ate interest. And the general answer is that the price which will be 
necessary to bring forth a given supply is that price which equals 
the greatest cost of producing said supply, supposing differences of 
cost to exist; and the volume of supply which will follow the ap- 
pearance of a given price is that volume which will have as its great- 
est cost an amount equal to said given price. 

Test of a Cost. — It follows from the relation between cost 
and supply prices above brought out that one method of testing 
whether or not a given element is a cost is to see whether or not it 
appears in the supply price. Supposing competition to be free, does 
the producer insist on getting a price higher than would otherwise be 
necessary just because the element under consideration has to be 
supplied? If the answer is "yes," that element is certainly a cost; if 
the answer is "no," that element is not a cost. 

II 
Theory of Cost 

Concerned with Entrepreneur's Cost. — We have seen that 
the supply prices of the normal supply schedules of producible goods 
are quite certain to be in general the costs of production. But, as 
there is considerable room for misunderstanding with respect to the 
meaning of cost, it seems necessary to make some more specific com- 
ments on this matter. First, it is important to note that the costs 
with which we are here concerned are costs to the entrepreneur, the 
person or persons responsible for the production of goods. This 
obviously grows out of the fact that we are interested in costs as 
determinants of supply prices, and supply prices are the prices which 
the entrepreneur sets up as necessary to the forthcoming of supply.^ 



^ There is a good deal of criticism directed against the prominence given 
by most economists to the standpoint of the entrepreneur. This criticism 
does not seem to me justified. The entrepreneur is the person, natural or 
legal, who undertakes the responsibility of production — decides the kind, 
amount, and method of production. As entrepreneur, he must hold the place 
of first importance. Perhaps a function of such magnitude ought not to be 
delegated to private persons at all; but whoever undertakes this task neces- 
sarily holds the center of the stage. 



314 PRINCIPLES OF ECONOMICS [XXV 

Concerned with Immediate Costs. — In saying that we are 
concerned here with entrepreneur's cost, we almost of necessity 
affirm that we are concerned with immediate rather than ultimate or 
intermediate costs. The steel which a producer of automobiles buys 
as raw material is of course a product^ and so has its own cost which 
indirectly must be a cost of the automobiles. In turn, the factors 
necessary to the producing of steel, namely : pig iron, coke, etc., are 
products having their costs, which costs, therefore, must indirectly 
be costs of the automobiles, remoter costs, intermediate costs. 
Finally, there must be factors beyond which we cannot go, the 
original raw materials given by nature, the earth itself, the services 
of laborers, etc., — what we call ultimate or primary costs.^ But, 
though there are costs other than the immediate ones, we are not, 
generally speaking, concerned with such other costs, in our present 
connection. To this it is necessary to make the one exception of 
primary costs incurred by the entrepreneur himself and not to be 
purchased from other persons, for example, the risk burden of the 
business. 

Money Costs : Explicit and Implicit. — The largest constituent 
in entrepreneur's cost is usually direct money cost — ^the money out- 
lay for factors of different sorts which he buys on the open market^ 
for example, raw materials, fuel, machinery, labor, the use of capital, 
etc. A closely allied constituent consists of the money value of such 
of the above purchasable factors as the entrepreneur himself fur- 
nishes. Thus, the individual entrepreneur commonly supplies labor 
services of much importance which he might purchase on the open 
market. Again, in almost all cases he is obliged to put in some 
capital of his own. Further, he may use his own land, instead of rent- 
ing from someone else. Now, for his labor services, he will naturally 
try to get as good wages as he would have tO' pay others for the 
same services. Similarly, on the capital which he put in, he will of 
course insist on getting the usual interest. So, for the use of his 
land, he will expect as large a return as the rent which he would 



*The former designation lays stress on the logical finality of these costs; 
the latter places them in their temporal or causal order. 



XXV] NORMAL SUPPLY SCHEDULES 315 

have to pay another landlord. Accordingly, in estimating what the 
product costs him, he will make allowances for all these items. They 
will, therefore, constitute a part of the cost of production, — quasi- 
money costs, we might call them, or implicit money costs, as con- 
trasted with his direct money outlay which we may call explicit money 
costs. 

Cost of Entrepreneur's Contribution. — We have just re- 
marked on two constituents of entrepreneur's cost, explicit and im- 
plicit money costs. There is still a third which must not be ignored. 
In addition to the various contributions often made by the entrepre- 
neur which he might buy from others, — implicit or quasi-money 
costs, — ^there is another, one corresponding to his distinctive func- 
tion as entrepreneur. Some person natural or legal must undertake 
the responsibility of deciding, willing, that production shall go for- 
ward, else of course there will be no production. This distinctive 
function of the entrepreneur is, therefore, a factor in production. 

But the fact that the distinctive contribution of the entrepre- 
neur is a necessary factor in production is not sufficient to make it 
an element in cost. In order to be such an element, it must also be an 
economic factor, a factor having an economic character, having value. 
But the question whether this factor has an economic character is not 
so easily determined as in the case of the other factors which have 
been considered. Just because the services of labor, of capital, and 
of land are purchasable on the open market, we have no difficulty 
deciding whether or not they have value, for that is evidenced by 
the prices at which they are bought and sold. The distinctive func- 
tion of the entrepreneur, on the contrary, cannot thus be bought and 
sold. The assumption of final responsibility and a certain residue 
of management cannot be separated from the ownership of the busi- 
ness, hence cannot be delegated to anyone else, cannot be hired from 
anyone else, therefore cannot be bought and sold, so cannot have a 
price to prove its economic character. It follows that we can ascer- 
tain whether or not this factor in production has economic value and 
so is a true economic factor, only by finding that at the margin the 
total return to undertakings has a money value in excess of all costs 
of the kinds already enumerated, that is, explicit and implicit money 



3i6 PRINCIPLES OF ECONOMICS [XXV 

costs. In short, business in general must yield a profit, if the dis- 
tinctive services of the entrepreneur are to be accounted as having 
value, hence as being economic factors, and therefore as entering 
into the cost of production. 

Meaning of Profit. — But at this point it becomes quite im- 
portant to avoid a possible misunderstanding as to the meaning of 
this word profit. Profit is the implicit price of those services of the 
entrepreneur which are peculiarly his own, distinctive of his office. 
We do not have a profit, in the strict sense, just because we have a 
return in excess of the money outlay, the explicit money cost. Such 
an excess would very likely be necessary to cover the wages due the 
entrepreneur as a laborer or to cover the interest due him as having 
supplied a portion of the capital. The excess in return which spells 
profit must go beyond the implicit, as well as the explicit, money 
cost. Thus, a small merchant investing $2,000 and clearing $1,600 
a year from the business might be thought of as getting 80 per cent 
on his investment; when in fact $1,300 out of the $1,600 was the 
wages of his labor as manager, salesman, etc., while $120 was interest 
on his $2,000 at 6 per cent ; so that his true profit was only $180 or g 
per cent. 

Profit a Part of Cost. — That this peculiar contribution of the 
entrepreneur, or the profit representing that contribution, is at the 
present time a true cost of production can scarcely be doubted, and 
is seldom denied by economists.^ Generally speaking, the prices 
of products are high enough to insure that entrepreneurs shall get a 
return in excess of all money costs, explicit and implicit. During 
the late war, most governments, when making contracts for supplies 
and when taxing business, assumed that, as a matter of course, pro- 
ducers must be allowed to make from ten to fifteen per cent gross 
profit or five to ten per cent net profit — profit in excess of interest. 
It seems to follow that, in the opinion of practical men, true profit 
commonly is, and in fact must be, an element in cost. 



* Some economists hold that profit would not continue to exist as a cost 
under a static set of conditions. Some even hold that this element is not a 
part of cost at present. For comments on some arguments in support of 
this opinion, see Note 4 in the Appendix. 



XXV] NORMAL SUPPLY SCHEDULES 317 

Interpretation of Profit. — We have seen that profit forms a 
necessary element in the cost of production: the supply price of a 
commodity — the price necessary to bring out the marginal units of 
supply — must be great enough to include a profit to the entrepreneur 
as well as to cover the other items which have been enumerated. This 
topic, profit, must not, however, be passed without a further word 
of explanation as to how the word is to be interpreted. There has 
been from the first, and continues to be, considerable confusion in 
economic writing in respect to the proper method of computing profit. 
Even business practice is not wholly uniform, though the interpre- 
tation which will here be given is probably the generally accepted 
one. Profit proper should be computed on the basis of the capital 
invested, not on the basis of the outlay. Thus, let us suppose that 
$50,000 is invested in a given business ; that this business yields an 
annual output of 100,000 units; that the cost per unit — profit not 
included — is $4; and that the rate of profit proper required is 8 per 
cent. Under these conditions, the producer does not say: "Since 
each unit of product costs me $4, and since 8 per cent of this is 
$.32, I will supply the commodity in question for $4.32"; instead, 
he says: "Since I have in the business an investment of $50,000, 
since 8 per cent on this is $4,000, and since the other costs equal $4 
per unit, I will supply the commodity at $4 plus $4,000 divided by 
100,000 units, that is, for $4.04." * 

Rent Commonly a Part of Cost. — In the above account of 
entrepreneur's cost, it was more than once implied that such cost 
includes rent, that which is paid for the use of land unmodified or 
modified only by such improvements as are practically irremovable 
and indestructible. We seem to be justified in doing this, in view of 
the precise nature of the problem before us : What are the elements 
included in the cost of the individual entrepreneur? For, from this 



* This of course does not mean that producers would not be glad to get 
the larger profit reached by the former method of computation. If they 
are regulated by government and have to get the consent of government in 
fixing their price, they often try to induce the regulator to adopt the method 
of reckoning v^rhich gives the larger profit. But where competition is free, 
producers will in the long run offer to supply the commodity provided the 
price is high enough to give them a proUt on the capital actually invested. 



3i8 PRINCIPLES OF ECONOMICS [XXV 

standpoint, rent must, in the great majority of cases, be looked on 
as a part of cost. The reason for this is that, in the great majority 
of cases, a given piece of land may be put to many different uses, 
and the individual entrepreneur will be obliged to compete against 
other entrepreneurs who want that land for other purposes, just as 
he would be obliged to compete against them for labor services or 
capital services. That is, rent would participate in determining the 
entrepreneur's supply price j'ust as truly as wages or interest. 

Disutility or Pain-Cost Not Included. — One or two further 
comments will complete this long discussion of cost of production. 
First, we note that entrepreneur's cost, as above described, does not 
in the main include what is often called psychic or disutility cost. 
What this sort of cost means is best seen in the case of labor. While 
to the entrepreneur the cost of labor is his money outlay for that labor, 
to the man who supplies it, the cost of that labor may be the dis- 
comfort, weariness, lack of leisure, which supplying the labor in- 
volves; that is, he may think of these as constituting the sacrifice 
which he is making when he furnishes the labor.^ Some writers, 
indeed, have insisted that this is the only cost which deserves the 
name. It is the true, the real cost of production, they say. Doubt- 
less such a view of the matter has some point ; but it is not sound 
doctrine in our present connection. We are here concerned with 
supply prices, and are interested only in those costs which influence 
the entrepreneur in fixing his supply prices. But, these, obviously, 
must be his own costs, his own sacrifices, not those of the persons 
from whom he purchases particular contributing services. But his 
costs, in the case of the contributing services of other persons, are 
plainly the sums of money which he pays for those services. When 
we come to consider the principles governing the prices of the pri- 
mary factors of production, those factors behind which we cannot go, 
such as the original raw materials, the uses of the earth's surface, 
labor services, etc., we shall find that, with some of these, disutility 
does play, or may play, a part in determining their prices. In that 



^ The laborer may, however, have in mind the fact that he can get wages 
from some other employer. In that case we have, not a psychic or disutility 
cost, but an opportunity cost. 



XXV] NORMAL SUPPLY SCHEDULES 319 

part of our study, therefore, we shall have to recognize the influ- 
ence of disutility. But in our present connection it is of interest 
to us only in so far as it determines the attitude of the entrepreneur 
himself, — that is, his attitude in settling what reward is necessary to 
compensate him for the peculiar sacrifices incident to his position as 
entrepreneur, in other words, what profit he must insist on having. 

Prices of Cost-Goods Constant. — Another comment which 
needs to be made in this connection is that from the standpoint of 
normal price, the prices of cost-goods, materials, labor, etc., are as- 
sumed to be constant, fixed. We conceive the entrepreneur as look- 
ing over the field and saying to himself : I shall have to pay so much 
for a place of business, so much for material, so much for labor, 
so much for the use of borrowed capital, and so on. In addition, 
I must get something for the capital and labor which I myself put 
in ; and, as I am not in the business for my health, I must get some- 
thing more for my trouble and risk, that is, I must have a profit. 
From these data, he computes what he must fix upon as his supply 
price. In doing this, he assumes the fixity of the prices of those 
goods and services which he has to buy. Of course, he knows that, 
as a matter of fact, those prices are not finally fixed, that they are 
liable to change even during the productive process. But, roughly 
speaking, they do not change. As a totality, they are fairly well fixed 
for the period of time with which he is concerned. Further, it is 
just his business to assume the burden of taking the inevitable risk 
of such changes. That risk he in part covers by adding something 
to his supply price; while at the same time he makes another addi- 
tion to that supply price, in order to provide compensation to himself 
for taking the chances involved. 

Illustrative Problems 

I. "Wages are the remuneration of the laborer for the sacrifices 
which he has to make in supplying labor services. It is ridiculous to 
call them a cost of production." 

Is there any reason why we should not say that wages are at once 
a cost and a remuneration? 



320 PRINCIPLES OF ECONOMICS [XXV 

2. To one laborer, on account of poor health, the day's work in a 
particular factory will mean much greater disutility than it means to 
another laborer in the same factory. Will this difference affect the sup- 
ply price of the commodity produced at the factory? 

3. A tailor carrying on business in a small town tells a prospective 
customer from Detroit that he can make him clothes more cheaply than 
an equally good Detroit tailor because his costs are lower, mentioning 
among other things the rent of the site where his shop is located. Can he 
legitimately treat rent as a cost in this case? Defend an affirmative 
answer. 

4. A railway lawyer is trying to prove before a court that a pro- 
posed 2 cents per mile passenger rate is unjust to his road in that it will 
not permit paying a reasonable profit, say 6 per cent, on the investment. 
He admits that this rate will be realized on the physical equipment of the 
road, valued at $5,000,000; but argues that the company has to provide 
for a pay-roll of $50,000 every month and ought to earn profits on this as 
well. Now this claim may or may not be reasonable. It all turns on 
whether providing for this pay-roll involves . . . Finish the sentence. 

Ill 
The Normal Supply Schedules of Increasing-Cost Goods 

We have seen that the supply prices of the normal supply 
schedules of producible goods are in general costs of production. But 
producible goods are not all of one kind. As noted in the begin- 
ning of this section, we distinguish at least two different classes of 
such goods in studying their normal price, increasing-cost goods and 
constant-cost goods ; and the supply prices which cost gives to these 
different sorts of goods are quite different. We take up first "in- 
creasing-cost goods." The general character of these goods was 
brought out in Chapter XI. The larger the amount of these goods we 
try to produce, the greater will be the cost of the additional units of 
product. In other words, the larger the amount produced, the greater 
will be the marginal cost of production. But the cost of producing 
any particular part of output determines the supply price of that 
part of output ; hence the marginal supply price must rise with every 
increase in the output. As a result, the normal supply schedule of 
increasing-cost goods must be of the sort earlier called typical, — sup- 



XXV] NORMAL SUPPLY SCHEDULES 321 

ply varying directly with price and vice versa. The table and dia- 
gram given for a typical market supply schedule on page 270 would, 
therefore, illustrate well enough the normal supply schedules of in- 
creasing-cost goods. With every rise in price, supply increases ; with 
every fall in price, supply diminishes. 

IV 
The Normal Supply Schedules of Constant-Cost Goods 

The second class of producible goods with which we have to deal is 
constant-cost goods. By these we mean goods the output of which 
can be increased from a very small tb a very large amount — so large 
as compared with the natural range of demand that it may be called 
indefinitely large — without substantial change in the cost of produc- 
tion. Emphasis is laid on "substantial," since it is probable that any 
change in the volume of output can seldom be effected without some 
change in cost. But, in the case of a host of manufactured com- 
modities, the degree of change in cost necessary to effect a given 
change in the volume of output is practically negligible. Thus, only 
under quite exceptional conditions would the cost of producing the 
numberless articles supplied by five- and ten-cent stores be increased 
by any ordinary increase in the amount supplied. Doubtless it is 
possible to have in mind periods of time so long that decided changes 
in cost prices would take place. But normal price, from its very 
nature, is not concerned with periods of such length. The very idea 
or normality implies constancy with respect to the principal condi- 
tions; for, without such constancy, there would be no price which 
tended to prevail throughout the whole period, that is, there would 
be no normal price. 

The character of the normal supply schedule of goods of this 
sort is easily seen. By hypothesis there is no change in cost over a 
wide range of output. It follows that these goods have hut one supply 
price. At any price below this one, no supply will be forthcoming ; 
at this price, an indefinite amount will be available; and, at higher 
prices, no more will appear, since the amount at the one price is in- 
definitely large. It follows that the supply schedule of constant-cost 
goods takes the following form : At prices below the one supply price. 



322 PRINCIPLES OF ECONOMICS [XXV 

supply is zero ; at the one price, supply is indefinitely large or varies 
within the range specified in the hypothesis ; and, at prices above the 
one, supply remains at the same indefinite figure as at the one price. 
Such a schedule is given in the first 2 columns of the table on page 333. 

Output Adjusted to Demand. — One peculiarity of the supply 
schedule of this particular type of producible goods seems to call 
for special comment. This is the statement that, at the one supply 
price, supply is indefinitely large. Now this account of the matter 
must not be interpreted as meaning that producers actually get out 
and put on the market an indefinitely large amount of the product in- 
volved. Supply always means the amount sellers stand ready to dis- 
pose of at the given price; and, in the case of normal schedules for 
producible goods, standing ready does not necessarily involve that 
the given volume is actually produced if the given price is reached. 
Producers stand ready to go this far, but have time to experiment 
with the situation and of course will not effect such production unless 
they are warranted in doing so by the actual demand conditions. If 
they cannot usually market the goods they will not produce them, 
though their supply price has been reached. The appearance of their 
price is not alone sufficient to insure production. The volume of 
product is consciously adjusted to the actual demand. 

V 

The Normal Supply Schedules of Fixed-Supply Goods 

The preceding section was occupied with the consideration of the 
supply schedules of producible goods. We now take up the schedules 
of goods which are strictly non-producible or, for some reason, behave 
as if they were of this sort. They may be goods of which the stock 
is fixed, like the land on the earth's surface, or goods having a regular 
output but one which is fixed, like the annual uses of land as a site 
or as a something on which a crop can be raised. The former we 
might call fixed-stock goods ; the latter, fixed-output goods. We here 
designate them fixed-supply goods, because, as will appear in a mo- 
ment, the situation makes their normal supply constant and so makes 
this a characteristic mark for them all. 



XXV] NORMAL SUPPLY SCHEDULES 323 

Supply Price Anything above Zero. — We may take as one 

of the most important of these fixed-supply goods, the uses of land 
just mentioned. Thus, within the area of a given city, there are just 
so many sites, say 10, of a certain degree of desirabihty for busi- 
ness purposes. Broadly speaking, no human action can increase or 
diminish their number. From the standpoint of normal price, what 
will be their supply schedule? Doubtless their market schedule 
would present itself as similar to the one given on page 270. That 
is, the number offered would vary directly with the price. But the 
situation for the normal schedule is different. Normal price is not 
concerned with momentary tendencies as is market price, but with 
tendencies covering a period of some length, a period long enough to 
eliminate uncertainty with respect to real values and the real attitudes 
of possible buyers. Now, over any such period, the attitude of 
owners will be that all the uses of such sites must he marketed at 
some price — whatever price can be obtained. The site uses not being 
produced, the owners cannot save a cost of production by withhold- 
ing them from the market. Those owners would prefer to get higher 
prices ; but anything is better than nothing. Hence, in the long run, 
owners will offer all these uses of sites for whatever price they will 
bring. 

In this particular case of sites, there is another consideration which 
makes the period necessary to bring all the sites on the market a 
rather short one. While some types of non-producible goods are 
capable of indefinite preservation, hence can be reserved for future 
use, and so can profitably be withheld from the market for consider- 
able periods,^ nothing of the kind is true of the uses of a site. These 
cannot be preserved at all ; they are absolutely perishable, — live but 
for the moment. If the owner of a site does not sell the 1920 use 
of that site during 1920, he can never sell it at all. He can of course 
sell the 1921 use, the 1922 use, and so on ; but the 1920 use is gone 
forever. Doubtless, in the process of bargaining with possible ten- 
ants, it may be of advantage to owners to forego the opportunity to 



* Doubtless the owners of such goods will not carry out this policy 
indefinitely. The risks are too great; and man, being mortal, his interest 
in possible future gains is limited. 



324 



PRINCIPLES OF ECONOMICS [XXV 



dispose of some of the uses of a site. But the operation is evidently 
an expensive one ; and will not be engaged in to an indefinite extent. 
From all this it follows that, in this case of the ten sites, the supply 
of uses will be just ten at every price: — ^the supply will be a fixed, 
unchanging, supply. Accordingly, the normal supply schedule of 
these sites would read as in the accompanying table : lo offered when 
the price is $12,000; 10 offered when the price is $11,000; 10 offered 
when it is $10,000 ; and so on. 

Cases Among Producible Goods. — To get a perfect case of 
fixed-supply goods, we chose a special kind of non-producible goods, 
the annual uses of land. We find, how- 
ever, that cases of this sort arise among 
producible goods. Thus, the designation 
fixed-supply goods is obviously applicable to 
goods which were produced by some one no 
longer living. Another case is supplied by 
goods which have gone out of fashion. Such 
goods can, literally speaking, still be pro- 
duced ; but, not being longer wanted, they 
zmll not be produced, — they are economic- 
ally non-producible. A much more impor- 
tant case is that of some agricultural prod- 
uct between two harvests. Thus, roughly 
speaking, our stock of wheat cannot be in- 
creased from the end of the 1920 harvest to that of the 1921 harvest ; 
so that, during this peripd, the supply could not be extended beyond 
the existing stock. On the other hand, the prospect of a new crop 
putting in an appearance usually insures that the whole existing 
stock will pass into supply during the current year. Thus, the nor- 
mal supply for the year is identical with the existing stock, and so 
that supply is a fixed one. 

It is plain that these later cases of fixed-supply goods fulfil the 
condition from which their designation is derived much less per- 



Price 


Supply 


000 


No. OF 


DOLLARS 


SITES 


12 


10 


II 


ID 


10 


ID 


9 


ID 


8 


10 


7 


ID 


6 


ID 


5 


10 


4 


«o 


3 


10 


2 


10 


I 


ID 


S 


ID 


.8 


ID 


.7 


10 



* Remember that wheat is a fixed-supply good only when we are looking 
at it for the brief period between two harvests. Over a longer period, it is 
an increasing-cost good, having its price determined by a different law. 



XXV] NORMAL SUPPLY SCHEDULES 325 

fectly than the one first chosen for illustration. They do, however, 
fulfil that condition in a sufficiently large measure to merit the 
designation. In the process of price determination, they behave, in a 
general way, as do the strictly non-producible goods. It should be 
added that cases of this sort — quasi-fixed-supply goods we might call 
them — are likely to appear temporarily in quite unexpected places, in 
connection with all sorts of goods. But these will more naturally 
receive comment in a later connection. 



CHAPTER XXVI 

PRINCIPLES GOVERNING THE DETERMINATION 
OF NORMAL PRICE 

In the two preceding chapters we have discussed normal demand 
schedules, with the significances to consumers which lie back of 
them, and normal supply schedules, with the costs of production 
which in two cases lie behind these. It is through these normal 
demand and supply schedules that the normal prices of goods are 
determined. 

We are now, therefore, in a position to take up the di- 
rect study of those principles which are commonly given as govern- 
ing normal price. 

We shall treat in succession the three classes of goods the supply 
schedules of which were studied in the last chapter, taking them up 
in reverse order, — fixed-supply goods, constant-cost goods, and in- 
creasing-cost goods. By this process we prepare ourselves to handle 
almost every case of normal price determination; for the three 
classes of goods named have their normal prices determined in three 
dififerent ways, and those three ways include practically all the ways, 
and indeed quite all the most important ones, in which normal price 
can be determined. 

Speaking generally, we may say that the goods of the first class 
have their prices determined from the demand side only — through 
the prices of the demand schedule; that goods of the second class 
have their prices determined from the supply side only — through 
the prices of the supply schedule; and that those of the third class 
have their prices determined by elements from both demand and 
supply — through the prices of both the demand and the supply 
schedules. 

We begin with that class the prices of which are determined 
from the demand side only. 

326 



XXVI] NORMAL PRICE DETERMINATION 327 



Normal Price of Fixed-Supply Goods 

We will take as an example of fixed-supply goods copies of the 
Basel edition of Sir Thomas More's Utopia. Suppose that, at about 
the same time in the year 1925, three or four finds are made, bring- 
ing on the market a new supply of these books amounting to ten 
copies. Suppose, further, that the demands of libraries and private 
collectors are such that the aggregate demand schedule is as follows : 
I copy wanted, if price is $200; 2 copies, if price is $175; 4 copies, 
if $160; 6 copies, if $125 ; 10, if $100; 11, if 
$90 ; 14, if $75 ; and so on. Under these 
conditions, what must the price tend to be, 
and what principles will regulate that price ? 
The accompanying demand and supply 
schedule shows that the price could not be 
above $100; for, if it went above this figure, 
4 buyers would withdraw, making demand 
deficient, and, in order to guard against this 
result, the sellers would bring price down to $100. On the other hand, 
price could not go down to $90 ; since, if it did one new buyer would 
come in, making demand excessive, a result which $ioo-buyers would 
have to guard against by bidding price up to at least $91. x\ctual 
price, then, must tend to be some price between $91 and $100, 
inclusive. 

The first and most obvious comment on this case is that our 
familiar law of supply and demand is still operative. A price must 
be reached at which demand and supply are equal. If demand and 
supply were not quite equal at one of the prices given in the schedule, 
the necessary equating would be effected in practice by compromise 
prices between those given. Equality of demand and supply would 
be reached at $95 or $94 or $97 or at some other figure between $90 
and $100. Further, it is manifest that the law of supply and de- 
mand is regulating not merely market price but normal price also. 
The market price, under this law, would in successive hours or days 
or weeks probably run both above and below $100, perhaps mostly 



•emand Price S' 


UPPLY 




DOLLARS 




I 


200 


10 


2 


175 


10 


4 


150 


10 


6 


125 


10 


10 


100 


10 


II 


90 


10 


14 


75 


10 


16 


60 


10 


20 


50 


10 



328 PRINCIPLES OF ECONOMICS [XXVI 

above. But under the same law, as a final resultant, a normal price 
of $ioo would be affirming itself. 

We have noted that, in this case of fixed-supply goods, the law 
of supply and demand is still operative and is determining normal 
price. 

It may be worth while to add that the law may here be af- 
firmed in a somewhat special sense. Since supply is, by hypothesis, 
constant and so demand must do all the changing, and since supply 
is in the long run identical with stock, we are justified in restatmg 
the principle as follows : In the case of fixed-supply goods, the nor- 
mal price must tend to he that price or some one of that series of 
prices which will cause demand to become equal with the unchanging 
supply. Or, more briefly, the normal price must tend to be that one 
or at least some one of that series which will equate demand to 
stock. 

In seeking a deeper knowledge of the processes by which nor- 
mal price is determined, the natural procedure is to note first the re- 
lations between the price which is necessary to equate supply and 
demand and the particular supply prices and the particular demand 
prices which are the immediately effective ones in the regulation of 
price. These, we remember, are the marginal demand price and 
the first extra-marginal supply price for the upper limit of price and 
the marginal supply price and the first extra-marginal demand price 
for the lower limit. Are all of these operative in the case of fixed- 
supply goods, and if not, which ones are? The answer is quickly 
given: Only the demand price limits are operative. 

As we saw in our first analysis of the Utopia example, at least 
one reason why normal price could not be above $ioo is that, unless 
price is as low as $ioo, the last increment of demand will not appear 
at all, and sellers, therefore, will be obhged to bid actual price down 
to $ioo to insure disposal of the stock. That one of the two variables 
fixing the upper limit of price which comes from demand, the mar- 
ginal demand price, is thus actually operative, But the other variable 
fixing this limit, the one which comes from supply, is not operative. 
Sellers are not compelled to bid price down in order to prevent the 
appearance of a new supply ; for there is no new supply to appear 
— supply is constant. In other words, the first extra-marginal sup- 



XXVI] NORMAL PRICE DETERMINATION 329 

ply price has no share in fixing the upper Hmit of actual price. That 
limit is fixed by the marginal demand price only.^ 

Turning, now, to the lower limit of price of this same com- 
modity, it is evident that actual price could not go down to $90 be- 
cause this would make demand increase by one copy, thus compelling 
buyers to bid price up to some higher figure in order to exclude this 
increment of demand. But, on the other hand, buyers do not have to 
hold price up in order to keep in the marginal supply; for, by hy- 
pothesis, supply is constant and therefore will not fall with a de- 
clining price. In short, that one of the variables fixing the lower 
limit of price which comes from demand — ^the first extra-marginal 
demand price — is the only one actually operative. From this 
analysis, it follows that, in the case of fixed-supply goods, the normal 
price must he one of the prices ranging from a limit fixed by the 
marginal demand price, and that only, down to a limit Hxed by the 
first extra-marginal demand price, and that only. 

The above formula confines itself to defining the limits within 
which normal price must tend to fall. But, as already noted, actual 
demand schedules for most commodities are continuous, — show 
changes in the volume of demand for practically every change in 
price. In consequence, the marginal and the first extra-marginal de- 
mand prices will be in juxtaposition and therefore actual price can- 
not go below the marginal demand price at all without reaching the 
first extra-marginal demand price. In practice, then, it will usually 
be sufficient to define normal price by one of these limiting moments, 
the marginal demand price. Hence the following formula: 

Principle. Generally speaking, the normal price of a 
fixed-supply commodity must tend to coincide with its mar- 
ginal demand price. 

The formula just given makes the marginal demand price the 
decisive factor in determining the normal price of fixed-supply goods. 
But as was explained in Chapter XXIV, the marginal demand price 
must usually be an expression of the marginal significance to the 
marginal buyer, as estimated by himself, of the quantity of a com- 



^The limit is the first price above. 



330 PRINCIPLES OF ECONOMICS [XXVI 

modity he proposes to buy; and this, in turn, must be determined 
by his estimate of the marginal utility he expects to derive from that 
quantity of the commodity. Further, the marginal significance or 
utility to the marginal buyer is the general marginal significance or 
simply the marginal significance. And, finally, in any formula con- 
taining the phrase "marginal demand price," we can substitute the 
phrase "marginal significance" or the phrase "marginal utility." 
Hence the following formula: 

Principle — The Marginal Significance or Utility Prmciple. 

Generally speaking, the normal price of a fixed-supply 
commodity must tend to be that price "which expresses the 
marginal significance or utility of the existing stock of said 
commodity. 

Illustrative Problems 

1. During the current year, there came on the market from various 
sources twelve specimens of a certain rare object. If the ultimate de- 
mand schedule proves to be as follows : i wanted at $60 ; 2 more at $55 ; 
4 more at $50 ; 5 more at $45 ; 6 more at $40 ; etc., what price will in the 
long run tend to be reached? Prove. 

2. In a certain year the output of wheat proved to be 2,000 millions 
of bushels. The ultimate demand schedule for the year ensuing till the 
next harvest was as follows: 1,600 million bushels wanted if price were 
$1.30; 1,800 millions if price were $1.25; 2,000 millions if $1.20; 2,200 
millions if $1.15; and so on. 

(a) What price would tend to prevail for that year? Prove in 
detail. 

(b) What would determine it? 

(c) What price would tend to prevail if the demand moved up a 
step, making the schedule 1,800 millions at $1.30; 2,000 millions at $1.25; 
2,200 at $1.20; 2,400 at $1.15; and so on? 

(d) What price if demand moved up two steps, making the sched- 
ule : 2,000 millions at $1.30; 2,200 at $1.25; and so on? 

(e) What price if demand moved down two steps, making the sched- 
ule : 1,200 millions wanted at $1.30; 1,400 millions at $1.25; 1,600 at 
$1.20; 1,800 at $1.15; 2,000 at $1.10; and so on? 



XXVI] NORMAL PRICE DETERMINATION 331 

3. "In 1348-49 the black death carried off from one-third to one- 
half of England's workingmen. In consequence wages greatly ad- 
vanced." 

(a) Explain the advance in wages on the basis of the Law of Sup- 
ply and Demand given on page 286, constructing Jor the purpose im- 
aginary demand and supply schedules. 

(b) Explain the advance in wages on the basis of the Marginal 
Significance principle given above. 

(c) Discuss this statement: "Wages rose because the demand for 
the laborers who were left had greatly increased." 

II 
Normal Price of Constant-Cost Goods 

In sharp contrast with the class of goods just considered, fixed- 
supply goods, are the constant-cost goods with which we now deal. 
The former had no supply price, or perhaps better, their supply 
price was indeterminate. Constant-cost goods, on the other hand, 
have just one supply price. Within the limits of the demand likely 
to develop, an indefinitely large supply will be forthcoming at that 
one price, while none will be forthcoming at any lower price. As a 
hypothetical example of this class of goods, we will take the wooden 
chair used in the fifth problem on page 159. This chair is a con- 
stant-cost good at the single price of 30 cents, so long as demand 
is not less than 500,000 and not greater than $2,000,000. That is, 
a price as high as 30 cents is necessary to bring out any supply at 
all, since this is the cost of production ; and this price will bring out 
a supply indefinitely large as compared with demand. 

The law of normal price for this case is easily derived. As we 
found in Chapter XXIII, the limits of price variation may be fixed 
by two prices from the demand side, or by two prices from the 
supply side, or by some combination of these. But, in this particular 
case, the operation of supply prices in fixing these limits is so de- 
cisive that demand prices may be ignored altogether. There is hut 
one price which supply conditions will permit to exist; that one, 
therefore, must prevail. This results from the fact that in this case, 
the limits fixed by the mairginal and first extra-marginal supply 
prices coincide. Our chair will not be supplied at all, unless the price 



332 PRINCIPLES OF ECONOMICS [XXVI 

is as high as 30 cents; and any additional chairs wanted will be 
forthcoming as long as this price is offered. The former condition 
insures that actual price cannot be lower than 30 cents ; the latter 
insures that it cannot be higher than 30 cents. It is thus rigidly fixed at 
this one point. The normal price of such a commodity must tend to co- 
incide with the single supply price without respect to demand prices.^ 

The principle just brought out, the exclusive dependence of con- 
stant-cost goods on the supply price, is so important that it seems 
best to give it the benefit of ample illustration. We take for this 
purpose our wooden chair. The accompanying table shows the 
single supply schedule for amounts between 500,000 and 2,000,000, 
and several hypothetical demand schedules. Strictly speaking, our 
supply schedule should show but one price. But, since producers 
who are ready to supply any amounts between 500,000 and 2,000,000 
at 30 cents will of course be ready to furnish these amounts at any 
higher price, we can without inaccuracy set down these figures for 
supply at the higher prices of the demand schedules; and, since this 
procedure will contribute to convenience, it is adopted in the table. 

Combining, now, supply schedule S with demand schedule A, it 
is plain that price must tend to be just 30 cents. Price could not be 
higher than this; since sellers, being ready to supply much more 
than the total amount demanded at 30 cents, will bid down to that 
figure in order to get as much of the market as possible. On the 
other hand, since there is nO' supply forthcoming at prices below 30 
cents, buyers will bid price up to that figure to insure getting what 
they want. Exactly similar reasoning would show that the price 
must necessarily tend to be just 30 cents with demand schedule B 
or C or D or, in fact, with any one we could imagine which made de- 
mand at 30 cents more than 500,000 and less than 2,000,000. 

But not only will price be 30 cents, the single supply price, it 
will rest at that point uniniluenced by demand prices.^ The most 



' Of course this does not mean that actual price can be emancipated from 
all relation to demand prices. Actual price could never be higher than the 
marginal demand price. But this simply means that, if the marginal demand 
price were not as high as the single supply price, the commodity iij question 
would not be produced at all, and hence the problem of its price determination 
would not arise at all. 

^ Remember, however, the qualification already noted. 



XXVI] 



NORMAL PRICE DETERMINATION 



333 



clearly decisive proof of this assertion is to be found in the fact that 
the same price would be reached if our demand schedule were so 
altered as to put the demand prices which might influence the matter 
qiiite outside of the price hound to prevail. Thus, let us suppose 
the schedule D to be so altered that from 50 cents to 15 cents there 
is no change in the volume of demand. Now, under this schedule 
as under the others, normal price must tend to rest at 30 cents ; buy- 
ers will hold it up to this point ; sellers will hold it down to this 
point. But with a normal price of 30 cents, the marginal demand 
price for schedule E would have to be 50 cents, since that price is 
low enough to bring in the whole demand actually satisfied ; while 
the first extra-marginal demand price would have to be 15 cents, 
since no addition to demand takes place till this price is reached. 
But neither of these prices influences a price set at 30 cents. A 
marginal demand price of 50 cents would permit actual price to rise 
to 50 cents; while a first extra-marginal demand price of 15 cents 
would permit actual price to fall as low as 20 cents. But, in fact, 
actual price cannot rise above 30 cents, nor fall below 30 cents. Its 
position, therefore, is uninfluenced by the demand prices. 



Supply 


Price 

S 






Demand 000 






Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


000 


Dollars 


A 


B 




C 


D 


E 


500-2000 


3 


2 


3 




3 


5 


5 


500-2000 


2 


10 


12 




15 


20 


20 


500-2000 


I 


SO 


51 




60 


80 


80 


500-2000 


.75 


300 


500 




810 


1 100 


1 100 


500-2000 


•50 


500 


750 




1020 


1400 


1400 


500-2000 


.40 


600 


895 




1200 


1520 


1400 


500-2000 


•30 


700 


950 




1540 


1840 


1400 





•25 


1000 


1210 




2000 


2560 


1400 





.20 


1500 


1800 




2560 


2800 


1400 





• IS 


2500 


3000 




3800 


4563 


2000 



We are now in a position to observe the final results of our study 
of constant-cost goods. These goods, we have just shown, must 
tend to have a price coincident with their single supply price, un- 
influenced by their demand prices. But that single supply price, as 
we learned in the chapter on supply schedules, is the cost of pro- 



334 PRINCIPLES OF ECONOMICS [XXVI 

duction to the representative producer ; and demand prices, as we 
learned in the chapter on demand schedules, are expressions of the 
marginal significance or utility of the commodity to marginal con- 
sumers. Making the substitution of terms, therefore, we may say 
that the price of a constant-cost commodity tends to coincide with 
its cost to representative producers, uninfluenced by the significance 
or utility of the commodity to consumers.* 

The result of the preceding discussion has been to set up cost 
of production as the determinant of the normal price of constant- 
cost goods. However, a word of caution is here necessary. The 
power of cost to determine price is derived from its power to in- 
fluence the forthcoming of supply. Its influence, therefore, is ex- 
ercised through the future rather than the past. It is not because 
the existing product had a cost that price has to equal cost, but he- 
cause the future output will have a cost. From this fact it results 
that unless there is call for future production, cost can have no 
influence on price. If, for example, a change in fashion makes the 
existing stock of a particular style of shoe in excess of any possible 
demand at a price as high as cost, there will obviously be no need 
for further production, and so cost will have no influence on the 
price. Such a commodity will, as seen in our classification of com- 
modities, pass into the class of fixed-supply goods. Its price will 
then become purely a matter of demand prices and, therefore, of the 
forces lying behind those prices, namely, significance or utility. To 
insure our recognition of this point, our principle will explicitly state 
that the continued production of the commodity in question must be 
called for. 

Another caution is suggested by the consideration on which the 
last was based, — that cost of production acts only through its re- 
lation to future product. Cost of production may change, rise or 
fall ; and, after every change, it will be the new cost which must de- 
termine price. To anticipate this difficulty, some writers have argued 
that we ought to say "price must equal cost of reproduction." To 
this, however, the answer of Cairnes is perhaps sufficient: All 
scientific principles assume constancy of conditions ; the cost of which 



Remember the qualification. 



XXVI] NORMAL PRICE DETERMINATION 335 

is decisive at any period is the cost of that period, conditions sup- 
posed to be unchanged. But, if anyone prefers, there is no serious 
objection to saying cost of reproduction. 

The principle brought out in this discussion may now be formu- 
lated as follows : 

Principle. The normal price of constant-cost goods, 
the continued production of which is demanded, must ap- 
proximately equal their cost to representative producers. 

Illustrative Problems 

1. From a cement factor promoter in 1901 : "We can easily satisfy 
any fair-minded person that our proposition is a veritable gold mine. 
Cement can be put on the market by a well-equipped mill at a cost of 
about $1.75 a barrel, while it is selling for $4, thus giving a profit of 
over 100 per cent. With the supply of raw material practically unlimited, 
our mill will soon be turning out 600,000 barrels per year, and our annual 
profits will be nearly $1,500,000. You can't afford to stay out." 

Supposing the facts to be as stated, what economic law was over- 
looked in drawing conclusions? 

2. "Labor once spent has no influence on the future value of any 
article." 

(a) Show that this is true as applied to the wooden chair which 
was used in working out our principle. 

(b) Does the above statement, admitting it'to be true, invalidate our 
principle ? 

3. At a certain time the price of whiskey in this country was about 
fifty cents, the cost of producing it. The United States government 
thereupon levied on each gallon produced a tax of one dollar. What 
naturally happened to the price of whiskey? Why? 

4. "Let us suppose that five or six concerns are supplying the build- 
ing brick used in a certain district, and that by a new method of manu- 
facture they manage to double their output for the former expenses of 
labor. What will happen as regards the price of brick? From our 
knowledge of what competition usually does, we are apt to say: the 
price of brick will fall 50 per cent. This may be the final result, but not 
necessarily so. . . . Manufacturers in normal times will increase their 
production of brick. ... To take off the extra supplyof brick they must 



336 PRINCIPLES OF ECONOMICS [XXVI 

find a wider circle of demand. ... It may, however, happen — not in the 
case of brick probably, but in large articles of limited consumption — that 
there is no such circle of demand at lower levels; then what will happen 
is that the manufacturers will cut down their output to the same quan- 
tity of brick as before, and maintain the former high price. ... It is 
contrary to all experience to think that employers will voluntarily raise 
wages or pay higher interest — because costs have decreased. They only 
do so under compulsion of fear that their rivals will cut the feet from 
under them. Where competition is active it will often seem as though 
reduction of costs were almost immediately followed by fall in prices 
of products, but, in the last resort — and that is what concerns us in 
seeking for a universal law of value — the new prices are determined by 
the lower and wider levels of want which are ready to take up increased 
supply of the majority of ordinary commodities." 

The above quotation is taken from the writings of an able economist. 
It has been modified at a few points to eliminate ambiguities. I think, 
however, that it does not misrepresent his views. In any case, it brings 
out a way of looking at the matter which the student should be familiar 
with. 

(a) State clearly what is the precise point which the author seems 
to be trying to make. 

(b) Show that it is unsound. 

5. A certain residence in Ann Arbor is taxed each year, let us say, 
$42, of which sum $12 is properly chargeable to the land while the re- 
maining $30 is chargeable to the house. Under the operation of the two 
principles of normal price which we have now had, the $30 will really 
be paid by the tenant, being shifted from the landlord to him, while the 
$12 will not be shifted and so, as far as the future is concerned, will re- 
main on the landlord. Explain how it is that things come out this way. 

Ill 

Normal Price of Increasing-Cost Goods 

Fixed-supply goods, we have found, have their prices determined 
by demand forces only. Constant-cost goods, on the other hand, 
have their prices determined by supply forces only. But in the case 
of increasing-cost goods with which we now deal, forces from both 
sides participate. This grows out of the fact that the supply schedule 
is of the sort called typical in our first account of these schedules. 



XXVI] NORMAL PRICE DETERMINATION 337 

Since, by definition, the cost of these products increases as the out- 
put increases, their supply schedule will show a change in supply 
for every change in the supply price. But general demand schedules, 
as explained in Chapter XXIV, are practically always of the typical 
sort, showing change in the volume of demand with every change 
in price. Hence our present case is one wherein both schedules are 
of the regular type. In consequence, any price which does not 
equalize demand and supply sets up reactions tending to displace 
that price, on both the demand side and the supply side ; and these 
reactions influence the determination of the point where price finally 
rests, whether they come from the side of demand or that of supply. 
Normal price, then, for increasing-cost goods is determined by both 
demand and supply forces. 

Perhaps the best way to confirm this reasoning is to show by 
illustration ( i ) that every variation in either the demand schedule or 
the supply schedule would cause a change in price, and (2) that 
the determination of the new price would have been influenced, not 
by the changing element only, but also by the one which remained 
constant. The first point may be seen by a moment's study of the 
accompanying table, which gives three difl^erent schedules of the 
typical sort on each side. Whichever ones we combine at the outset 
(not including D"' or S''') if we keep the supply schedule constant 
and unite with it a different one of the demand schedules, a new 
price necessarily emerges. A precisely similar result is reached if 
any one of the demand schedules is kept constant and a different 
supply schedule combined with it. 

The second point is not so easily seen, but is no less certain. 
When a new price is fixed by the use of a new demand (or supply) 
schedule, that price after all is not made what it is simply by this 
new demand (or supply) schedule — it is also influenced by the 
schedule which was kept constant. To illustrate, let us start with 
two combinations both of which give a price of 55 cents, namely, 
demand schedule D with supply schedule S, and the same demand 
schedule with supply schedule S''', a schedule which shows supply 
unchanging from 53 cents to 57. Let us now substitute demand 
schedule D' in the two combinations successively and note the differ- 
ent results. The first experiment, putting D' with S, causes price 



338 PRINCIPLES OF ECONOMICS [XXVI 





Demand, 


000,000 oz 




Price 

CENTS 




Supply, 


000,000 oz. 




Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


Schedule 


D"' 


D" 


D' 


D 




S 


S' 


S" 


S'" 


230 


190 


230 


210 


60 


310 


330 


290 


290 


240 


200 


240 


220 


59 


300 


320 


280 


280 


250 


210 


250 


230 


58 


290 


310 


270 


270 


260 


220 


260 


240 


57 


280 


300 


260 


260 


260 


230 


270 


250 


56 


270 


290 


250 


260 


260 


240 


280 


260 


55 


260 


280 


240 


260 


260 


250 


290 


270 


54 


250 


270 


230 


260 


260 


260 


300 


280 


53 


240 


260 


220 


260 


270 


270 


310 


290 


52 


230 


250 


210 


250 


280 


280 


320 


300 


51 


220 


240 


200 


240 


290 


290 


330 


310 


50 


210 


230 


190 


230 



to advance i cent, from 55 to 56. The second experiment, putting 
D' with S'"" makes price advance 2 cents, from 55 to 57. The 
obvious reason is that, in the latter case, unchanging supply left to 
demand alone the equalizing of demand and supply and so price had 
to advance two full steps ; while, in the former case, increasing sup- 
ply made possible the equalizing of demand and supply i cent earlier, 
and so stopped the rise of price at one step. 

We have seen that the normal price of increasing-cost goods 
must tend to be one which is influenced by the forces of both demand 
and supply and so by all four of those moments which fix the limits 
of price variation, namely, the marginal and first extra-marginal 
demand prices and the marginal and first extra-marginal supply 
prices. But in Chapters XXIV and XXV we learned that the de- 
mand prices are expressions of the significance or utilities of the 
several amounts of the product in question, while the supply prices 
are the different marginal costs of production. Hence in the above 
statement we may substitute for the phrases "demand prices" and 
"supply prices" the words "significances" and "costs." In short, the 
prices of increasing-cost goods are determined by both significance, 
or utility, and cost. More precisely the price of an increasing-cost 
good must not go above that price which expresses its marginal 
significance nor up to one which equals its first extra-marginal cost, 
and must not go below its marginal cost nor down to a price which 
expresses its first extra-marginal significance or utility. 



XXVI] NORMAL PRICE DETERMINATION 



339 



If we assume for the sake of convenience that both the demand 
and supply schedules are perfectly typical and regular, it follows that 
the two upper limits would fix the same price, as in the schedule on 
page 281, and the same would be true of the two lower. It would 
then leave our formula still adequate if we were to omit the limit 
fixed by extra-marginal significance or cost and say : "The price of 
an increasing cost product must be one which approximately ex- 
presses its marginal significance or utility and equals its marginal 
cost." 

Before finally accepting this formula, however, it seems desir- 
able to make some comments in the nature of cautions. First, in 
order to anticipate an objectionable interpretation which some have 
made, it is perhaps best to insert the word "normal" before marginal 
cost. The marginal cost is the greatest cost at which production is 
being carried on, and this might be taken to mean the cost to pro- 
ducers who are quite behind the times in methods and facilities and 
are perhaps losing money but have no other alternative than going 
on till they become bankrupt. But actual price is commonly lower 
than cost to such producers ; hence the formula breaks down. The 
answer is that such persons are not true marginal producers. A 
marginal producer drops out if price falls below his figure, while 
the persons in question continue whatever the price. They are far. 
within the margin, or, better, are wholly abnormal elements. Not 
their cost, but the normal marginal cost, determines price. 

Another point calling for a moment's attention is the following: 
If either or both of the schedules considered are discontinuous, price 
will not necessarily coincide exactly with either marginal significance 
or marginal cost. But it will be in so far fixed by both of these 
that, on the one hand, it must not go above the marginal significance 
nor down to the first extra-marginal significance ; while, on the other 
hand, it must not go below the marginal cost nor up to the first 
extra-marginal cost. 

Finally, it is of course always possible to argue that, in making 
up a formula, either one of the determinants might be chosen and the 
other one omitted, on the ground that either implies the other. But 
if we affirm the relation of price to either factor, making no men- 
tion of the other, there is danger that we shall be understood to mean 



340 PRINCIPLES OF ECONOMICS [XXVI 

that the one we do mention is alone responsible for the price, to the 
entire exclusion of the other. So, in the opinion of the writer, it is 
unsafe to carry the ellipsis further than we do in the formula now to 
be stated. ' 

Principle. The normal price of increasing cost goods, 
the continued production of which is demanded, tends to be 
a price which both expresses the marginal significance of 
the output and equals its normal marginal cost. 

Illustrative Problems 

1. Suppose that the production schedule of silver reads as follows: 
At a marginal co^ of 55 cents, 170 million ounces can be furnished; at 
a marginal cost of 56 cents, 175 millions ounces; at 57 cents, 180 millions; 
at 58 cents, 185 millions; at 59 cents, 190 millions; at 60 cents, 195 mil- 
lions; at 61 cents, 200 millions; at 62 cents, 205 millions; at 63 cents, 210 
millions ; etc. Suppose, secondly, that the demand schedule is as follows : 
160 millions ounces wanted, if price is 65 cents; 165 millions, if price is 
64 cents; 170 millions, at 63 cents; 175 millions, at 62 cents; 180 millions, 
at 61 cents; 185 millions, at 60 cents; 190 millions, at 59 cents; 195 mil- 
lions, at 58 cents; 200 millions, at 57 cents; etc. 

(a) Make out a table giving the ultimate demand and supply sched- 
ules. 

(b) What must price tend to be? Prove. 

(c) What will it tend to be if demand moves up two steps, becoming : 
170 millions wanted if price is 65 cents; 175 millions if price is 64 cents; 
and so on. Prove. 

(d) What determines price in these two cases? 

2. "At the present time (1896) silver is being produced at a marginal 
cost of approximately 65 cents per ounce. But the price of silver is in 
the long run determined by its marginal cost. Hence it is ridiculous to 
expect that the adoption of free coinage by the United States will raise 
the price of silver, as measured in gold, to $1.29 per ounce, or any other 
figure above 65 cents." 

Admitting that the normal price of silver must in the long run coincide 
with marginal cost, still the above conclusion is unsound. Explain. 

3. Suppose the production schedule in Problem i to be changed so 
as to read as follows: At a marginal cost of 55 cents, 175 millions ounces 



XXVI] NORMAL PRICE DETERMINATION 341 

can be furnished ; between 55 cents and 59 cents no change is possible ; 
at a marginal cost of 59 cents, 500 millions ounces can be furnished; at 
60 cents, 525 millions ounces; and so on. 

(a) What would price tend to be when the demand schedule was 
the same in Problem i (a) ? Prove. 

(b) What would price tend to be if the demand schedule were 
moved up as in Problem i (c) ? Prove. 

(c) What would price tend to be if the demand schedule were 
moved up two more steps so as to begin : 180 millions ounces wanted at 
65 cents? Prove. 

(d) What is the point to be made? 

4. The author of a recent textbook in Economics expresses himself 
on the relation of cost to price in this vein : In the case of reproducible 
goods, "cost of production seems of commanding importance." "In fact, 
however, marginal efficiency (utility) is the real determinant of price," 
"cost of production adjusts itself to this." "There is an abundance of 
silver below the surface that is not mined because it will not pay; if the 
marginal efficiency or value of silver should rise, these more expensive 
grades would at once be marketed and the new marginal cost of produc- 
tion would adjust itself to the price." 

(a) Construct a sentence running parallel to the last one quoted, but 
exactly reversing the roles of marginal utility and marginal cost, whereby 
it would seem to be proved that marginal cost really determines price 
while marginal utility merely adjusts itself to price. The sentence should 
start out something like this: "Generally speaking, it would seem as if 
marginal utility chiefly regulated price. In fact, however, marginal 
cost is the real determinant; marginal utility adjusts itself to this. Below 
the present demand for silver there are numerous layers of demand which 
are now merely potential because the corresponding utilities are below 
the present market price; if, now, the marginal cost of producing silver 
should fall, and so the price should fall, these lower layers of demand, 
etc. . . ." 

(b) Show that both the original quotation and our substitute are 
inadequate, — that the price reached in the former case is influenced by 
marginal cost, while that reached in the latter case is influenced by mar- 
ginal utility. 



CHAPTER XXVII 

SPECIAL CASES OF NORMAL PRICE 

The general principles governing normal price have been brought 
out in the preceding chapter. But there are some cases of a rather 
unusual character which call for special treatment. Some, on ac- 
count of peculiar complications, are not provided for at all in the 
foregoing principles. Others could be fairly covered by a careful 
interpretation of those principles; but, because of certain peculiarities, 
further explanation is needed to guard against misunderstanding. 
In still other cases, there is reason for attempting a special state- 
ment, because, although the principles already laid down quite plainly 
apply to them, it is possible for various reasons to go deeper, to find 
some more ultimate statement of the process whereby price is de- 
termined. 

I 

Rare Products 

A very interesting special case is that of produced goods which 
are so limited in possible amount that they behave almost like non- 
producible goods. We speak of them as rare products. Notable ex- 
amples are the very rare metals, such as radium, iridium, even plat- 
inum. We should probably have to count in the same class various 
vegetable products, special brands of tea, tobacco, or wines. 

As already indicated, the distinguishing mark of this class of 
goods is the fact that the total possible output is extremely restricted 
as compared with the demands at very high prices. In consequence, 
increases in output through increased expenditure, though they can 
be made, are practically negligible. Goods of this sort give us a 
production or supply schedule which looks something like a regular 
increasing-cost schedule. In fact, however, the extreme smallness 
of increase in output with rise in price dififerentiates these from the 
typical cases such as we had in silver. The accompanying schedule, 

342 



■ XXVII] SPECIAL CASES OF NORMAL PRICE 343 

an imaginary one for a very rare brand of tea, may be taken as 
representative. Every considerable increase in output takes place 
while cost is still quite low, and after cost has passed $25 the ad- 
ditions are all in single pounds and even fractions of a pound. If 
this supply schedule be combined with the demand schedule marked 
D, a price of $250 per pound results, and this price is really deter- 



1 


Demand 




Price 


Supply 






000 POUNDS 




DOLLARS 


000 POUNDS 




D" 


D' 


D 


S 


S' 


I 


6 


3 


500 


11.683888 


40 


2 


8 


5 


450 


11.683885 


25 


3 


10 


6 


400 


11,68388 


18 


5 


12 


8 


350 


11.68387 


15 


6 


13 


10 


300 


11.68385 


13 


8 


15 


12 


250 


11.6838 


12 


10 


18 


13 


200 


11.683s 


10 


12 


25 


15 


150 


11.683 


8 


13 


40 


18 


100 


11.682 


6 


15 


60 


25 


50 


11.680 


5 


18 


100 


40 


25 


11.675 


3 


25 


120 


60 


10 


11.650 


2 


40 


160 


100 


5- 


11.600 


I 


60 


180 


120 


4- 


11.500 




100 


200 


160 


3. 


11-350 




120 


500 


180 


2.50 


II. 100 




160 


700 


200 


2. 


10.800 




180 


1,500 


500 


I.7S 


10.500 




200 


3,000 


700 


1.50 


9.900 




500 


10,000 


1,500 


1.25 


9- 




700 


15,000 


3,000 


I. 


7-7 




1,500 


20,000 


10,000 


•75 


6. 




3,000 


30,000 


15,000 


.50 


4- 





mined in just the same way it would be if the possible output for 
each year were absolutely fixed at 11,000 pounds, — by the marginal 
significance. The fact that the output can be increased beyond 
11,000 pounds, and the further fact that in the end the price actually 
coincides with the marginal cost of production, have really nothing 
to do with fixing the price at $250. Marginal significance alone is 
effective. 

This contention is most plainly established by noting the effect 
of raising or lowering the demand schedule and seeing how the re- 
sults differ from what they would be if we had a typical case of 



344 PRINCIPLES OF ECONOMICS [XXVII ' 

increasing-cost goods. Thus, when demand schedule D', represent- 
ing demand as having advanced two steps all along the line, is com- 
bined with the supply schedule, price also advances two steps, from 
$250 to $350. So' demand schedule D'', which represents one re- 
sulting from a decline of two steps in demand, causes the price also to 
drop two steps, from $250 to $150. If now our supply schedule had 
been a typical one wherein supply appreciably increased as the mar- 
ginal expenditure increased — represented in schedule S', the result 
would have been quite different. Our original demand schedule D 
combined with this new supply schedule would have given us, as 
before, a price of $250. But the change to D' would have caused 
an advance in price, not of two steps, but only of one, from $250 
to $300. So, combining D'' with the new supply schedule would 
have caused a drop in price, not of two steps, but only one, from 
$250 to $200. 

The reason is plain. In the latter case, the substantial increase 
in output, as price rose under schedule D', brought supply and de- 
mand together at an earlier price ; while the substantial falling off 
in output, as price fell under schedule D", brought supply and de- 
mand to equality at the earlier point. With the original supply 
schedule, both of these conditions were lacking. The increase as 
price rose was negligible, the decrease as price fell was negligible. 
The new prices, therefore, were fixed without respect to supply or 
cost. We have here in effect a fixed-supply or fixed-output com- 
modity, the price of which is determined by marginal significance 
alone. 

II 

Joint-Cost Products 

In studying not a few producible goods, we strike a complication 
due to the fact that several different commodities emerge from the 
same productive process. Thus, the dairyman simultaneously and by 
productive efforts, a large share of which are inseparable, brings into 
existence milk, butter, cheese, beef, and hides. The refining of pe- 
troleum yields not only common illuminating oil, kerosene, but also 
vaseline, gasolene, and naphtha. Again, the coal tar resulting from 
the distillation of coal for the making of gas gives us a whole line 



XXVII] SPECIAL CASES OF NORMAL PRICE 



345 



of by-products, including various drugs, perfumes, and a large 
number of dyes. Now, in cases like these it is impossible, save in 
very small measure, to isolate the share in the cost of production 
which is properly chargeable to each of the several products. This 
being true, we surely cannot apply to these goods, without qualifica- 
tion, the principle laid down for other producible goods. 

The special theory needed here was set forth by Mill. It is that 
the price of each of the individual products must he such as to 
equalise supply and demand for that product; while the money value 
of the whole ffroup of products must equal their cost of prodtiction. 
In consistency with the modern analysis which goes behind demand 
to significance or utility, we should change the first part of this 
formula to read "the price of each of the individual products must 
tend to be that price which expresses the marginal significance of 
the quantity of that particular product which is put upon the mar- 
ket." The second part of the formula can remain unchanged. 

The argument in support of this principle is as follows : First, 
the price of each member of the group of products must be such as 
to express its marginal significance, because, under the conditions 
given, the quantity of each of the products is virtually fixed, and 
hence it comes under the laws of fixed-supply goods. This, of 
course, does not mean that the supply of each commodity is literally 
unchanging; but that its changes do not take place in response to 
conditions which affect that commodity itself only, but rather in re- 
sponse to conditions which affect all the commodities of the group. 
When, therefore, the price of any one of them is in process of de- 
termination, the supply of that one is virtually fixed ; and hence the 
principle governing its price is the one which governs the price of 
fixed-supply goods. But the principle in question makes the price 
of these goods depend upon marginal significance; and so marginal 
significance governs the case now before us. 

It is no less certain that the prices of all the members of the group 
must be such that the sum total of their money values will equal their 
joint cost of production. This result is bound to be brought about 
through processes already thoroughly familiar. If at any point the 
sum total of the group prices should rise above this total cost of the 
group products, capital will move into the industry, supply all along 



346 PRINCIPLES OF ECONOMICS [XXVII 

the line would increase, marginal significance would fall, and so 
prices would fall. Conversely, if the total costs were not covered by 
the total values, capital would withdraw from the industry, the supply 
of the several commodities would fall ofif, their marginal significance 
would rise, and so prices would rise. Doubtless this readjustment 
would be much more complicated and hence much slower than in 
the case of isolated individual products, but in the long run it would 
inevitably come about. 

Principle. The price of each member of a group of 
joint-cost products tends to he that price which expresses 
the marginal significance or utility of the quantity of that 
particular product which is put upon the market, provided 
that the sum of the money values of all products of the 
group tends to equal their joint cost of production. 

Illustrative Problems 

1. Enumerate some products of a Michigan farm which might be 
thought of as by-products. 

2. Discuss the question as to whether the transportation between De- 
troit and Jackson of products of quite different types, for example, coal 
and dry goods, truly gives rise to a case of joint -cost products. 

3. "The recent fall in the price of cotton is largely due to the im- 
proved manufacture and (increased) uses of cotton-seed oil." — Marshall's 
Economics of Industry, page 225. 

Explain why these facts should tend to cause a fall in the price of 
cotton. 

Ill 

Diminishing-Cost Goods 

If the wooden chair, the output schedule of which was presented 
in Chapter XXVI, is taken in the earlier stages of this schedule, it 
belongs in the class of diminishing-cost goods, — the more output 
producers try to furnish, the smaller is the cost per unit. This case 
we sometimes treat as a third subdivision of variable-supply goods. 
The general principle for variable-supply goods that price tends 



XXVII] SPECIAL CASES OF NORMAL PRICE 347 

to equal cost, if properly interpreted, is really adequate here, and 
proper interpretation only requires us to remember that the cost of 
production meant in our principle is the cost which is representative 
at the very time mentioned, not at an earlier or a later date. Never- 
theless, as this case is one of unusual practical importance, it seems 
to deserve special comment. 

The theory is comparatively simple. So long as the demand for 
commodities of the type considered is still relatively small, persons 
producing them are obliged to employ expensive methods of produc- 
tion; hence cost and, so, price is high. Presently, demand shows 
a large increase, and in consequence producers are able to realize 
the various gains of large-scale production, with the result that cost 
and, so, price is greatly diminished. Accordingly, if we wish to 
look at the period which includes these changes as a totality and 
state the law which governs that period as a totality, we have to 
say that price tends to equal the lowest of the costs of production. 
The importance of this law is best seen in connection with the theory 
of investment. In the earlier stages of a new industry, while crude 
or experimental methods are being employed, price is so high that 
producers who intend to introduce improvements which will greatly 
reduce cost are wont to anticipate therefrom enormous profits, and 
perhaps attempt to attract investors by representations to this efifect. 
But investors should remember that, just because it is going to be 
possible to reduce cost of production, the price itself is bound to fall, 
and the great profits described by promoters will, in all likelihood, 
fail to be realized. 

The principle may be succinctly stated as follows : 

Principle. The price of diminishing-cost goods tends 
to equal their cost to producers working on the largest scale 
justified by the existing conditions of demand, — monopoly 
being excluded. 

IV 

Fixed-Supply Income-Bearers 

Another special case is furnished by the fixed-supply income- 
bearer, for example, a piece of land rented for business purposes. 



348 PRINCIPLES OF ECONOMICS [XXVII 

First, with regard to income-bearers in general, we remark that, 
between their prices and their incomes there must tend to prevail 
at all times a fixed ratio approximately equal to the current rate of 
interest. When the rate of interest on money loans is approximately 
5 per cent then, between- the price of an automobile, let us say, which 
is to be used for purposes of hire and the net money income derived 
from that automobile, — due allowance having been made for repairs, 
replacement, labor services, and so on, — the ratio' is bound to be ap- 
proximately I oo to 5 or 20 to I. 

Now, the establishment of this ratio may conceivably be brought 
about in either of two ways : ( i ) the price of the automobile hav- 
ing been fixed, the income may move up and down till it settles at 
a figure just 1/20 of the price of the automobile, or (2) the income 
having been fixed, the price of the automobile may move up and 
down till it settles at a figure just 20 times as great as the income. 
Which will it be ? This depends surely on which of the two things, 
the income or the price of the auto, is free to move, and so able to 
put itself in the required relation to the other. With a commodity 
like the automobile, the one which must do this is surely the net 
income. For the automobile is a producible good, and, as we have 
already learned, prices of producible goods must approximate their 
costs of production. The price of the automobile, therefore, is not 
free to move. The income, however, moves with perfect freedom. 
If the net incomes derived from renting automobiles are too large 
considering the price of machines, then competition will increase, and 
in consequence rentals and incomes will decline. If incomes are too 
small, competition will lessen, whereupon rentals and incomes will 
increase. Accordingly, we may say of a producible income-bearer, 
that its price is first fixed and to this price the net income is ad- 
justed.^ 

Passing, now, to non-producible income-bearers such as land, we 
find ourselves facing a very different problem. No element of cost 



^ The student must remember, however, that the price of constant-cost 
goods is not always governed by cost. A necessary condition was expressed 
in the phrase, "the continued production of which is demanded," which ap- 
pears in the formula on page 340. Producible income-bearers at times pass 
into the status of non-producible ones. 



XXVII] SPECIAL CASES OF NORMAL PRICE 349 

is here in operation. Utility or significance only can affect price ; 
and the particular significance which affects it is obviously that given 
off by the land for a certain definite time. In short, the first thing 
to be fixed is, not the price of the land as a whole, but the price of 
a year's use of the land, its income ; which income, having been fixed, 
determines in some way the price of the land itself. 

Here again, as with producible income-bearers, the relation be- 
tween the price of any income-bearer and its income is fixed in 
advance ^ by the existing ratio between capital in general and the in- 
come therefrom. When 5 per cent is the prevailing rate of interest, 
we can be pretty siire that the net yearly income of a piece of ground 
which commands a price of $1,000 is about $50. 

In this respect, then, the piece of ground and the automobile are 
alike. But, in the matter of the causation, as we said, the cases are 
entirely different. The income of the machine adjusts itself to its 
price or cost; the price of the land adjusts itself to its income. We 
cannot say: The land is worth $1,000, hence its net income must be 
$50. Rather, we must say : The net income of the land is $50, hence 
its value must be about $1,000. To use another illustration, sup- 
pose a certain building site regularly yields a net income of $100, 
and that the current rate of interest on long-time loans is about 5 
per cent. Then, the price of the site will tend to be as many dollars 
as .05 is contained in 100, or $2,000. The usual procedure, when 5 
per cent is the rate, is to multiply the income by 20, which gives 
the same result as dividing it by .05. If, now, we put into formal 
shape the point here elaborated, we have the following : 

Principle. The price of an income -hearing property 
not '.capable of duplication tends to equal the sum of money 



'This is not to say that the income-bearer in question has no weight in 
determining the ratio between capital in general and the income therefrom. 
Doubtless every transaction involving an exchange of present wealth for the 
right to a series of future incomes helps somewhat in firing the rates at 
which all such exchanges take place. But as we have already seen, the price- 
making forces come to ahead, so to speak, in a particular class of transactions, 
— those which are marginal, those in which marginal significance or marginal 
cost or both are determined. Accordingly, we can safely treat almost any 
particular transaction of the kind here engaging us, as one to which is being 
applied a ratio of exchange already determined elsewhere. 



250 PRINCIPLES OF ECONOMICS [XXVII 

which, lent at the current rate of interest, would yield a 
yearly income equal to the net yearly income of the said 
property. 

Illustrative Problems 

1. If a certain mining stock pretty generally yields a net income each 
year of $54 per share, what would its price tend to be, supposing that 
the usual rate of return expected in such lines of industry is about 7 
per cent? Prove. 

2. If the dividend of the above stock fell to $37, what would you 
expect the price of the stock to become? 

3. Suppose you are considering the purchase of a $100 government 
bond, untaxed and paying 2 per cent interest. What price could you 
reasonably pay, if the rate commonly obtained on securities of this grade 
was 1.9 per cent? Prove. 

4. Here is a piece of farm land which regularly yields a net income 
of $1,700. What would its price tend to be when the rate of interest in 
such lines was about 5.5 per cent? 

5. Here is a site in a large city which yields a ground rent of $51,000 
a year. Suppose that the Henry George ideas came to prevail in said 
city, so that the tax on the site named is fixed at 93 per cent of its rent. 

(a) What would the price of the site tend to be when the rate of 
interest was about 5 per cent? 

(b) What would it be if the rate of taxation were raised to 100 
per cent, the rate of interest remaining 5 per cent? 

6. Supposing that there were no interfering causes, what would you 
expect the price of a government bond bearing 2 per cent interest to do in 
times when the rate of interest has been exceptionally high for many 
months? 

7. A certain building site regularly yields a net income of $300 a 
year. This fact would cause it to have what market value when the 
rate of interest was 8 per cent ? 6 per cent ? 5 per cent ? 

8. A certain automobile which is hired out, regularly yields its owner 
a clear income over all expenses of about $300 per year. With interest 
at 6 per cent, this fact would cause the car to have what market value? 
Is this a reasonable problem? 



XXVII] SPECIAL CASES OF NORMAL PRICE 351 

9. An automobile costs $1,200 and lasts only three years. With 
interest at 6 per cent and with 6 per cent added for the trouble and risk 
of running an automobile livery, what must an automobile earn during a 
year to make the business pay? 

ID. A certain building site is worth $22,000. With interest at 6 per 
cent what surplus over other expenses must any business located on the 
given site pay in order to make the use of the site for that purpose 
profitable? Interpret this problem so as to make it a legitimate one. 
Interpret it so as to make it an illegitimate one. 

V 
Price Under Monopoly 

As we have emphasized repeatedly, our discussions of price 
determination assume perfect freedom of competition. The con- 
sistent distribution of topics would therefore seem to require that 
the discussion of monopoly should appear separate from, and sup- 
plementary to, the treatment of price in general. We shall not, 
however, be able to undertake an adequate treatment of the topic in 
any connection, so that it seems best to touch upon some of its most 
significant features here. Moreover, this procedure is in a sense 
justified by the fact that price-determination under monopoly is not 
a process entirely different from those already described, but 
merely a variant from them. Monopoly, as it were, injects into the 
situation a new condition under which the principles already noted 
as operative work out the result. 

The first point to be made is that, in respect to its more immedi- 
ate determination of price, we have under monopoly merely a spe- 
cial case of fixed-supply goods. The supply of the monopolized good 
is a fixed one ; but this fixedness is not of natural origin, is not due 
to any absolute limit nor to the limit of our capacity to produce. 
Rather, the monopolist consciously, arbitrarily, limits the amount 
produced, or, at any rate, the amount put on the market. It follows 
that, immediately speaking, the law governing monopoly price is the 
same as that given for fixed-supply goods. The normal price of 
goods sold under the condition of monopoly must be one which ex- 
presses the marginal significance or utility of the output. The only 



352 PRINCIPLES OF ECONOMICS [XXVII 

qualification needed is one which recognizes the artificial nature of 
the limit set. We might then restate the formula as follows : The 
normal price of monopoly goods tends to he one which expresses the 
marginal significance of the supply as fixed by the free choice of 
the monopolist. 

The second point to be noted gives us a more fundamental gov- 
erning principle, — a principle which tries to define the normal price 
of monopolized goods, the price which, in view of all the circum- 
stances, including "the free choice of the monopolist," tends to be 
established. The use of the word "normal" here may sound strange ; 
for it is probable that most people think of monopoly and the monop- 
olist's free choice as doing away with all normality of price, — as fix- 
ing price in a purely arbitrary way. This, however, is going much 
too far. Monopoly prices, though less submissive to natural laws 
than competitive prices, are not, after all, entirely free from such 
laws. The monopolist is coerced by conditions in fixing his prices, 
not according to his own caprice, but in conformity with certain 
broad principles over which he has no control. 

In the first place, if a monopolist puts his price too high, he 
will be disappointed in finding his gains smaller than they would be 
if he had set his price lower. Thus, suppose that petroleum is 
a monopolized product, and that a section of its demand schedule is 
as follows: 1,900 million gallons wanted if price is 9 cents; 2,500 
million if price is 8 cents; 3,000 million, if 7 cents; 4,000 million, 
if 6 cents. Suppose, further, that the total cost per gallon is 4 cents, 
so that there is a clear profit of 5 cents per gallon if the selling price 
is 9 cents; of 4 cents per gallon, if price is 8 cents; and so on. If, 
under these circumstances, the monopolist fixes the price at 9 cents, 
he will clear $95,000,000, whereas at 8 cents he would have cleared 
$100,000,000. What he gains through larger profit on each unit 
of product he will more than lose by diminishing the total number 
of units sold. 

On the other hand, it would be foolish for the monopolist to go 
to the opposite extreme in carrying out a policy of lowering price 
in order to increase demand. Thus, if he puts the price down to 7 
cents, he will indeed cause demand to increase from 1,900 millions 
to 3,000 milHons ; but the lowering of profit on each unit will more 



XXVII] SPECIAL CASES OF NORMAL PRICE 353 

than ofifset this gain in amount sold. His net profit will drop to 
$90,000,000. In short, the self-interest of the monopolist will dictate 
that he fix on the price which insures that the product of the net 
profit per unit output into total output is the highest possible ; and 
this gives us the general principle determining normal price under 
conditions of strict monopoly. 

Principle. Broadly speaking, the normal price of any 
'monopoli::ed commodity tends to he that price which zvill 
secure the largest net return to the monopolist. 

A cursory examintion of the preceding analysis shows plainly 
that the cause which hindered the monopolist from pushing price 
upward indefinitely was the fact that as price rose demand fell ofif, — 
in other words, demand was elastic, varying inversely as price. If 
demand had diminished more rapidly with increase in price, the price 
actually established would have been still nearer cost of production. 
If demand had changed less rapidly with increase in price, price 
would have been put still farther above cost of production. Hence 
the following: 

Corollary. The tendency of monopoly price to rise 
above the competitive normal varies inversely as the elas- 
ticity of the demmid for the monopolised commodity. 

It obviously follows from this corollary that every cause which 
increases the elasticity of the demand for a given commodity dimin- 
ishes the tendency of price in said case to separate from the com- 
petitive normal. Thus, the appearance on the market of a com- 
modity which can be used as a substitute for some monopolized one 
diminishes our dependence on the latter and so makes its demand 
schedule more elastic. 

The preceding discussion has brought out the general principle 
governing normal price under monopoly. But it is possible to be a 
little more specific regarding one particular type of monopoly which 
has much prominence in our day. This is known as the capitalistic 
monopoly, — one which owes its origin to the control by the monopo- 
list of an exceptional volume of capital. Such a condition enables 



354 PRINCIPLES OF ECONOMICS [XXVII 

a man or group of men to attain the position of monopolist, to gain 
and maintain exclusive control of output, largely because it enables 
them to produce more cheaply than rivals and hence drive them out 
of business. But it is plain that, to succeed, monopolies of this sort 
must keep prices fairly low, — somewhere in the neighborhood of 
cost to outsiders; since otherwise competitors will be continually- 
starting up, and will have tO' be bought out at considerable cost or 
driven out by destructive commercial wars. Formulating this point, 
we have the following : 

Principle. The norm^tl price of goods produced by 
capitalistic monopolists tends to approximate a figure not 
much above cost of production to outsiders. 

Illustrative Problems 

1. Suppose the demand schedule for Milton's autographs to be as 
follows: I wanted if the price is $200; 2 if it is $175; 4 if $150; 5 if $140; 
8 if $125; 9 if $115; 12 if $100; 13 if $90; 15 if $75; 20 if $50; and so on. 

(a) If there came on the market 9 autographs, what price would 
they tend to have under free competition? 

(b) What price if all were owned by one man? 

(c) Answer the same questions, supposing the number of autographs 
to be 15. 

(d) Answer the same questions, supposing the number to be 20. 

2. When the United States Steel Company was fully organized, many 
independent producers desired the Trust to join with them in raising the 
prices of steel products. The authorities of the Trust, however, refused, 
thinking it expedient to maintain the old level. What do you suppose 
was the reason? 

Miscellaneous Problems in Price 

1. There come on the market eleven specimens of a certain rare 
object to be disposed of at the best price attainable. If the demand is as 
follows : I wanted at $65 ; 2 more at $60 ; 4 more at $50 ; 5 more at $45 ; 6 
more at $40; etc., what price will tend to be reached? Prove. 

2. In the last problem, suppose a tax of $5 to be levied on each speci- 
men sold. 



XXVII] SPECIAL CASES OF NORMAL PRICE 355 

(a) What effect on price would be produced? 

(b) Who would bear the tax in the end? 

3. A friend of mine owns in a Chicago suburb a house and lot which 
used to rent for $300 a year. Last year real estate in his neighborhood 
had a boom, with the result that his property increased in value $3,000. 
In consequence he raised the rent to $480. What is the matter with the 
economic doctrine involved? 

4. "If the state should inaugurate the policy of levying on the livery 
business a lo-per-cent income tax, the value of all plants devoted to this 
business would necessarily fall off 10 per cent." Criticize. 

5. "Every owner of a railroad, of a patent, of a book, or of a 
(monopoly) property of any kind, finds that he makes more money by 
putting prices down to figures that are reasonable, that is, to figures 
which correspond to the values to the buyers of the things sold, than by 
keeping them up beyond those figures." 

(a) Show that the words "which correspond to the values to the 
buyers of the things sold," are useless as a definition of "reasonable" 
prices. (Try to think of some object which has a price greater than that 
one which would express the value of the object to buyers.) 

(b) In the case of producible goods, what price is commonly con- 
sidered a reasonable one ? 

(c) When "reasonable" is understood this way, is it probable that 
the first half of Stickney's statement is true? 

(d) Point out some cases of monopoly of which the statement can 
be affirmed with a fair degree of accuracy. 

6. "Analogous arguments . . . might be made with regard to mu- 
nicipal railways, lighting companies, and water companies. These are 
all, for one cause or another, of a monopolistic character. The public 
enjoys no guarantee of fair treatment on account of any competition that 
can affect them." — Adams' Finance, page 264. 

What is the doctrine with respect to competitive industries which is 
implied in the last sentence of the quotation? 

7. "When the demand for wheat increases so as to exceed the ca- 
pacity of the best land, the price of wheat rises so as to leave an excess 
or surplus over cost of production, and this surplus is driven into the 
hands of the landowner as rent by the natural competition of tenants. 
But, now, the high price of wheat leads to the cultivation of inferior 



356 PRINCIPLES OF ECONOMICS [XXVII 

soils, which increases the supply of wheat so as to satisfy the demand, 
and thtis brings the price of wheat hack to its old place." 
Criticize the part in italics. 

8. A certain man improves the opportunity offered by a growing 
city of 40,000 inhabitants to develop a messenger service business, from 
which at the end of three years he finds himself getting a net return, 
after allowing himself wages for management, of $700. The capital in- 
vested, which includes a bank balance of $200 which he commonly main- 
tains, is only $500; but he has to provide for a pay-roll of about $200 a 
month or $2,400 a year. He now tries to sell out the business, asking for 
it $8,750. Assuming that the good will of the business is worth $500, and 
that 8 per cent is a reasonable rate of interest and profit, is the price 
proposed a reasonable one? Does the size of the pay-roll make any 
difference? Explain. ' 



CHAPTER XXVIII 

THE PRICES OF PRIMARY FACTORS AND 
DISUTILITY 

Final Price Determination. — In introducing- the study of mar- 
ket price, we explained that our complete treatment of the principles 
and processes of price determination would fall into three parts. 
The first two parts, one dealing with the more immediate processes 
of market price determination, and the second concerned with a set 
of the deeper forces involved in the determination of normal price, 
have been completed. These twO' studies have treated of the nature 
and operation of those processes with which the business man in 
general is most immediately concerned, and a knowledge of which is 
usually sufficient for his immediate purposes. There is a third set 
of forces, however, lying deeper than any yet treated, which it is 
now our task to study. We must now try to get beneath the surface 
processes already considered, to processes and forces which are, in a 
logical sense, ultimate ; to go beyond conclusions which are often 
merely provisional, to those which are in some sense definitive; to 
leave points of view which are partial, for one which includes the 
field as a whole. In a word, our task now is to attempt a considera- 
tion of those fundamental forces and processes which govern the 
field of price as a totality. 

Inadequacy of Our Previous Treatment. — The essential de- 
ficiency in our previous treatment of the price problem is tO' be 
found in the fact that, in all those cases in which cost of production 
has been represented as playing a part in price determination, we 
have assumed that nothing need he said about the determination of 
that cost itself. In other words, we have assumed that costs are 
data given in advance, determinate from the beginning. As we have 
pictured the matter, the entrepreneur, starting out to produce some 

357 



358 PRINCIPLES OF ECONOMICS [XXVIII 

commodity, finds that he must pay so much for raw materials, so 
much for tools and machinery, so much for labor, so much for the 
use of capital, and so on. In consequence of these outlays, and in 
consideration of his own sacrifices, he fixes upon a price which con- 
ditions the forthcoming of his supply, the supply price of a given 
quantity of the commodity in question. Since it is a supply price, it 
is bound to influence actual price, is bound, at any rate, to furnish a 
point below which actual price cannot go- if this increment of the 
supply is to be had. 

But, now, what are the outlays which the entrepreneur has to 
make? Plainly, they are nothing more than the sum of money 
values of the factors he puts into the product, such value in each 
case being equal to the price of the factor involved, multiplied by 
the number of units employed. That is, costs, in so far as they con- 
sist of outlays, are themselves nothing but aggregates of prices, the 
prices of the factors or cost-goods used up in the process of pro- 
duction. This applies not only to the factors and cost-goods which 
the entrepreneur buys on the market, but also, in large measure,^ 
to those which he himself contributes. If he supplies labor services, 
he cannot hope to get in return higher wages than the market rate 
for similar types of labor; nor can he get a higher rate of interest 
for the capital he himself puts into the business than the rate pre- 
vailing on the market. 

It follows from what has just been said that in treating costs as 
data given in advance, as independent of the problem of price de- 
termination, we have ignored quite evident facts. Costs are not 
fixed in advance. They are not fixed outside of the price-determinat- 
ing process. Being themselves dependent on the prices of cost- 
goods, the explanation of the process whereby they are determined 
forms an integral part of the total problem of price determination. 
In so far then as we have built on costs, as if these constituted a 
foundation below which it was unnecessary to go, we have left our 
task incomplete. Such a procedure was doubtless legitimate from 
the standpoint of what we called normal price, since it was reason- 



^The profit on capital received by the entrepreneur furnishes a special 
case. 



XXVIII] PRIMARY FACTORS AND DISUTILITY 359 

able to assume that, from the standpoint of the individual entre- 
preneur, for periods sufficiently short to be of interest to him, the 
prices of cost goods have in normal times a degree of fixity sufficient 
to warrant his acting as if they did not change. Nevertheless, from 
the point of view^ of the entire problem of price determination, there 
is a gap in our explanation. We have not explained the process by 
which the prices of cost-goods are determined, although it is now 
evident that these prices play a very important role in the process of 
price determination. 

Produced Factors Partly Covered. — This account of the in- 
sufficiency of our previous treatment of price determination, how- 
ever, needs some qualification, and comment upon this qualification 
will aid in further defining our present problem. A large number 
of the factors used by the entrepreneur in production are them- 
selves products. This being true, an account of the principles under 
which the prices of products in general are determined, must also 
explain, in part at least, the processes whereby the prices of those 
factors of production, which are themselves produced, are deter- 
mined. In fact, the great majority of cases to which our previous 
account of normal price is applicable, are not final products, that is, 
such as are destined for the direct satisfying of wants, but they are 
factors used in making these final products. It follows, therefore, 
that in treating immediate price determination and normal price, we 
have covered to some extent this type of factor or cost-goods as 
well as final products. 

At this point, however, we must again guard against over- 
statement. If, in our theory of the prices of products, those prices 
had been made dependent on cost of production solely, there would 
naturally have been no difference in the case of goods intended for 
final consumption and goods employed in further production. In 
fact, however, prices of goods for final consumption were repre- 
sented as influenced not only by cost but also by their importance or 
significance to consumers. But this significance to consumers as a 
determining element in price, cannot be directly applied to goods 
which are used only in p^-oduction. A footnote on page 303 called 
attention to this gap in our explanation. While affirming at that 



36o PRINCIPLES OF ECONOMICS IXXVIII 

point the almost certain influence of the significance of final or con- 
sumers' products on the prices of producers' goods used in their 
production, we then reserved further comment on this matter; and 
now, while studying the problem of final price determination, we are 
still facing the task of explaining the connection between the sig- 
nificance of the final products to the consumer and the prices of 
intermediate products entering into them. 

Primary Factors. — We have seen that our study of price 
determination needs to be supplemented in order to provide a fuller 
explanation of the prices of those products which serve as factors in 
further production. The case of factors which are not produced, 
factors behind which it is not possible to go in the analysis of the 
productive process, primary factors, — these, still more notably, 
present to us a supplementary problem, a problem which has to be 
taken up in any explanation of the final processes of price determina- 
tion. In attempting the solution of this general problem of the 
prices of factors or cost-goods, we shall confine our attention to the 
second case, that is, the case of primary factors, on the ground 
that, in so far as the case of produced factors has not already been 
provided for under normal price, the conclusions reached with 
respect to primary factors will be applicable without material change 
to produced factors. Accordingly we will now enter upon the task 
of answering the question : How are the prices of primary factors 
determined^ 

Different Solutions of Problem. — In economic texts, the prob- 
lem we have thus set ourselves has seldom been clearly isolated, 
being usually confused with that presented by the more superficial 
processes of price-determination which have been studied in previous 
chapters. Nevertheless, one may distinguish at least three types of 
doctrine concerning this problem, as being implicit in price discus- 
sion. One group of writers teach that the value or price of the pri- 
mary factors is determined solely by their marginal utility: the pro- 
ductive capacities and resources of man are progressively distributed 
over the whole field of production, from the most important products 
downward till they are all used, and their utility in the marginal use 



XXVIII] PRIMARY FACTORS AND DISUTILITY 361 

fixes their value. A second group find the sole determinant in the 
cost, — the disutility cost — of supplying directly the human elements 
and making available the elements coming from nature, outside of 
man. Psychic cost is the original cost of everything, and determines 
what we must pay to secure the forthcoming of supply. A third 
group recognize the presence of both utility and cost determinants 
in the process, advocating what is often called an equilibrium theory. 

The Doctrine of This Text. — The doctrine maintained in this 
text is a form of the equilibrium theory. It gives most weight to 
significance or utility, but it insists on recognizing the influence O'f 
disutility cost in the case of those primary factors which can be 
supplied only by processes which involve that element. It may be 
formulated for the sake of definiteness in the following statement: 

Principle — Significance-Disutility Principle. 

The price of any primary factors tends to be that 
price which expresses the effective significance or value 
of that factor over the whole held of production, and 
which also expresses a disutility, not less than the marginal 
one and not as great as the hrst extra-marginal one, in- 
volved in supplying the quantity of said factor which is 
actually supplied, in case such a disutility exists. 

In maintaining this proposition, we will begin with the second 
or disutility part as involving fewer difficulties in analysis and 
presentation. This topic will occupy the remainder of the present 
chapter. 

Primary Factors and Disutility. — It is a fact too evident to 
need argument that the supplying of those primary factors which are 
of human origin may, at any rate, involve a disutility or "pain-cost." 
Working or saving or taking responsibility can be carried so far as 
to be distasteful. Further, it cannot be doubted that at the present 
time, in societies which have attained to any high economic. develop- 
ment, the supplying of these services has, with many of the persons 
concerned, gone so far that disutility is actually felt. Much or 



362 PRINCIPLES OF ECONOMICS [XXVIII 

most of the labor furnished carries with it a psychic sacrifice, and 
the same is true of some part of the saving and responsibility-taking. 
Still again, it is a familiar fact that the disutility or pain-cost of 
supplying these human primary factors increases with the amount 
supplied and diminishes as that amount diminishes. That is, dis- 
utility varies directly with the quantity supplied. 

Human Factors Have Supply Prices. — Again, it cannot be 
doubted that the amount of supply is influenced by the disutility 
involved. Some persons, anyhow, supply less than they would if 
the disutility of doing this were diminished. Most of us do not work 
as many hours per week, or month, or year, as we would if there 
were no disutility attaching tO' our efforts ; and the same surely is 
applicable to saving and responsibility-taking. It follows that any 
primary factor of human origin may be expected to have a supply 
price for each different quantity of such factor supplied, that is, a 
price on which is conditioned the forthcoming of that particular 
quantity, and, therefore, may be expected to have a supply schedule 
closely analogous to the perfectly elastic supply schedule which 
appears on page 270. If, at any time, an increase in the amount is 
demanded, a higher price will be necessary to bring out that increase, 
and, conversely, a higher price will bring out that increase.^ 

Supply Prices Influence Actual Price. — But, admitted that 
primary factors the supplying of which involves a disutility have a 
supply schedule of the typical sort, it necessarily follows that such 
a factor would tend to have its price fixed by the same limiting 
prices from the supply side which are effective in the case of com- 
modities generally. That is, the actual price of such a primary factor 
could not go below the marginal supply price nor up to the first extra- 
marginal supply price. Buyers could not let price fall below the 
marginal supply price ; since, in that case, they would lose the mar- 



' Interesting exceptions to this principle have been noted, particularly this 
one : that the higher price of labor at times brings out, not a larger, but a 
smaller, supply. The men furnishing this factor prefer to increase their 
leisure rather than their income. But it would seem that this sort of thing 
must be looked upon as an irregularity only, not as materially affecting the 
whole course of things. 



XXVIII] PRIMARY FACTORS AND DISUTILITY 363 

ginal increment of supply. On the other hand, included sellers could 
not let actual price go up to- the first extra-marginal supply price ; 
since, in that case, they would let in an excess of supply and sO' 
would run the risk of failing to dispose of some portion of their 
offering. 

Disutility Principle Established. — The foregoing would seem 
to establish beyond question the second part of our principle with 
respect to the prices of primary factors, the part, namely, which 
affirms that the price of any primary factor tends to be a price which 
expresses a disutility not less than the marginal one and not as 
great as the first extra-marginal one involved in supplying the 
quantity of said factor which is actually supplied, in case such a 
disutility exists. 



CHAPTER XXIX 

THE PRICES OF PRIMARY FACTORS AND 
SIGNIFICANCE 

Whether or not the significance of factors in production has any 
considerable part in fixing their value or price is still a matter of 
controversy among economists. The vi^ide-spread acceptance of the 
so-called marginal productivity doctrine, which characterized eco- 
nomic writing perhaps twenty years ago, has been followed by some 
reaction. Indeed, not a few of the younger economists speak with 
some contempt of this whole point of view. Nevertheless, it is 
doubtful if anyone would have the hardihood to deny the existence 
of some connection between the significance of factors and their 
prices. For practically everyone assents without hesitation to the 
general proposition that, as far as buyers are concerned, there is 
no reason why factors should have any price at all except the fact 
that the products which result from the use of those factors have 
significance or value. Probably, in this case as in so many others, 
the real difiference between the advocates and opponents of the 
doctrine here maintained has respect to the degree to which the pre- 
sumable connection between the prices of factors and their impor- 
tance in products is realized. At one extreme will be found those 
who seem to speak as if there were almost exact correspondence 
between the significance of any factor in production and the price 
which it commands on the open market ; while at the other extreme 
appear a group of thinkers who seem to consider the correspondence 
between importance and price so slight as to be almost negligible. 
In the opinion of the present writer, neither extreme is defensible. 
Significance influences very greatly the prices of primary factors ; 
but precise correspondence between the two is surely not realized. 

Our defense of the contention that significance plays a large part 
in determining the prices of primary factors will follow two lines : 

364 



XXIX] PRIMARY FACTORS AND SIGNIFICANCE 365 

First, we shall try to show that there are conditions under which 
there is some clue to the significance of a specific factor in the 
particular productive processes in which it is employed, in which 
case the reciprocal competition of producers tends to give such 
factor a price expressing its effective significance over the whole 
field. Secondly, we shall try to show that, even under conditions 
where no such clue is to be had, where there is no way of ascertain- 
ing the significance of any factor in the particular productive pro- 
cesses in which it is employed, nevertheless the spontaneous work- 
ing of the price-making forces tends to give each factor a price ex- 
pressing the effective significance of that factor. In this chapter, 
we shall confine ourselves to the former of these two lines of 
argument. 

I 

Knowledge of Significance in Particular Operations when a 
Factor is Acting Alone 

In the first place, there is an appreciable number of cases in 
which only one of the factors involved is an economic factor. For 
example, let us suppose that the productive process involved is piling 
into proper shape a cord of wood just delivered, — a process requir- 
ing only a very simple form of labor. In such a case, manifestly, 
the buyer of the single factor required could, without difficulty, 
ascertain quite precisely the product of that factor — the physical 
result which it accomplished in the particular productive process ; 
since that product is simply the changed condition of the wood — the 
condition of being piled. Again, it is plain that the buyer of the 
factor could easily ascertain the significance of that factor in this 
particular productive process ; for, obviously, that significance is 
just the same as the significance of the product itself — the changed 
condition of the wood. 

Many examples analogous to this are supplied by laborers en- 
gaged in furnishing various sorts of personal services, including 
services to the household. These laborers may properly be regarded 
as acting alone, furnishing one factor which is operating, not jointly 
with other factors, but by itself. It is true that in such cases other 
factors are usually involved, but they may be disregarded because 



366 PRINCIPLES OF ECONOMICS [XXIX 

the quantity of these other factors used is so small, in comparison 
with the quantity of labor employed, that their influence is negligible. 

Free Land Available. — A much more important example of a 
single factor acting alone is found in new countries where there is 
an abundance of free land available to which labor can betake itself 
and make a living. Under these conditions, there is substantially but 
one factor, that is, labor, the other principal factor, land, being 
non-economic. It is true that, in cases like this, some little capital 
is needed, but the amount is so small that it may be regarded as 
negligible. Whatever the laborer produces, then, is recognized as 
his product in a specific and special sense. 

Numerous Cases Not Needed. — It may be objected to giving 
the cases just commented upon much weight in our present problem 
that, at the most, cases of the sort form but a small per cent of the 
total, so small, indeed, that one cannot help wondering if they have 
any influence in the matter. To this objection, the easy answer is 
that, in nearly all cases of price determination, it is small quantities 
of supply which are decisive, namely, the marginal and first extra- 
marginal increments. These, to be sure, must be sufficiently large 
to affect appreciably the total supply, else sellers would not trouble 
themselves to bid price down in order to include the marginal in- 
crement of demand, and buyers would not trouble themselves tO' 
bid price up in order to exclude the first extra-marginal increment 
of demand. But a very small per cent of the total is sufficient for this. 

Accordingly, a correct decision in respect to the question whether 
or not the cases of factors which act alone have any material in- 
fluence on the prices of those factors, turns on whether or not the 
cases where the specific economic product of a factor can be isolated 
occupy the crucial positions indicated : Do they lie at the margin ? 
There is certainly a possibility that they do occupy this position. 
Historians have nearly always agreed that, in the case of colonial 
America, the possibility, open to laborers, of going over the moun- 
tains into the unappropriated land constituted a first extra-marginal 
demand for labor which compelled the employer in the settled dis- 
tricts to bid wages up to a higher figure than they would otherwise 



XXIX] PRIMARY FACTORS AND SIGNIFICANCE 367 

have reached. Even in a highly developed and static society, it 
seems not unlikely that the types of casual labor, which largely act 
in isolation, play a considerable part in that they are exceptionally 
mobile, exceptionally determined to have the best price the market 
will justify. At any rate, this much is certain, that in so far as the 
type of labor which is substantially acting alone does in reality oc- 
cupy the crucial place at the margin, the price of that factor must 
tend to settle at a point not above the marginal significance of such 
labor, nor as low as the first extra-marginal. 

II 

Know^ledge of Significance in Particular Operations when Several 
Factors are Cooperating 

Allocation or Imputation of Economic Product. — We have com- 
mented on those cases where the particular significance of a factor 
can be ascertained because that factor, economically speaking, is 
acting independently, — all other factors are either non-economic or 
negligible in amount. But no one would contend that cases of this 
sort are predominant. Almost always many different factors are 
acting jointly. It follows, therefore, that, if we are to get much 
help from cases wherein the significance of the factor in particular 
processes can be ascertained, we must find some method of isolating 
the significance of an economic factor even when it is operating 
jointly with other economic factors. But this, in turn, requires that 
we should discover some process whereby we can isolate a speciiic 
portion of the product of the particular operation in which our factor 
appears, as being a portion which can legitimately be imputed or 
credited to that factor. The process by which such isolating of 
portions of the common product may be accomplished, if accom- 
plished at all, is frequently designated "imputation." To distinguish 
it from other analogous processes to which we may find it convenient 
to apply the term, we shall call the case before us "product imputa- 
tion" or "imputation of economic product." 

Meaning of Economic Product,^ — Before commenting on the 
possible solution of the problem of product miputation, we must 



368 PRINCIPLES OF ECONOMICS [XXIX 

realize quite fully in just what sense the word "product" is used in 
this connection. First, we surely must not think of ourselves as try- 
ing to discover some method of ascertaining- the literal product of 
each factor in a joint process. The very notion of accomplishing 
such a result is absurd. Literally speaking, the whole product is 
produced by all the factors acting together. All we can hope 
to do, all we need to do, is to isolate the economic product of the 
factor in question. By economic product we mean the portion of 
the product which we can properly treat as if it mere the product of 
the one factor under consideration. In other words, if in our eco- 
nomic conduct we behave as if a certain portion of the product were 
literally produced by the given factor alone, and find that, in doing 
this, we have done just the right thing, economically speaking, then 
that portion of the product which we treated as if it were the 
product of the factor in question alone, actually is the economic 
product of that factor. 

This case is most easily illustrated from the product rent of a 
piece of land used for farming. Let us start with the idea that land 
is of many grades in respect to efficiency; and that there is such an 
abundance of the land of the lowest grade which it pays to cultivate 
that much of it is unused when we have put under cultivation all 
that we need. In such a case, the lowest grade of land under culti- 
vation, called marginal land, will not be accounted an economic 
factor at all, will be a free good. If, now, an acre of better land 
yields to a certain amount of expenditure six bushels of wheat more 
than this marginal or non-economic land yields to the same expendi- 
ture, that six bushels of wheat will be properly credited to said 
acre of land as being, economically speaking, the specitic product of 
that land alone. This, of course, does not mean that those six bushels 
are produced by the land without the aid of the other factors ; but 
merely that we can behave as if this zvere the case and in doing sa 
will act wisely. In other words, a farmer wishing tO' cultivate this 
piece of land would act wisely were he to pay for the privilege of 
doing so a share of the product not in excess of six bushels. 

Surplus Method of Imputation.^ — Having now before us the 
concept of economic product, the question presents itself : How' far 



XXIX] PRIMARY FACTORS AND SIGNIFICANCE 369 

can this product be isolated, how far can the problem of imputation 
be solved ? One method of doing this is suggested by the illustration 
just used in explaining what we mean by economic product. That 
method we may call the surplus method, since it depends on showing 
that the factor which is under consideration yields a surplus over 
another specimen of the same kind of factor which is a non-eco- 
nomic factor. This particular method of imputation is habitually 
applied to land'; and has long been looked on as fairly adequate to 
isolate the specific product oi this factor in the particular operations 
where it is being employed. Since it isolates the product economi- 
cally imputable to the services of the land, it also, of necessity, 
isolates the importance or significance of those services ; and this, 
in turn, insures that those services shall have a price expressing a 
significance not as low as their first extra-marginal one, nor higher 
than their marginal one. It follows that land, or land services, when 
used in farming anyhow, may be looked on as a primary factor which 
in a very high degree realizes the principle we are defending, 
that is, the principle that a factor tends to have a price expressing 
its effective significance over the whole economic field. And it is 
probably fair to say that this view has been held explicitly or im- 
plicitly by the great majority of economists. 

Dosing Method of Imputation. — A second method of product 
imputation which has wide acceptance may be called the "dosing'' 
method. This method thinks of the entrepreneur as making a series 
of experiments in which all but one of the factors engaged in a joint 
productive process are kept constant, while successive units of that 
one are added. The addition tO' product which follows the addition 
of the last or marginal unit of this particular factor is accounted 
the economic product of that unit. Further, since the different 
units of said factor are reciprocally interchangeable, the addition to 
product which follows the addition of the marginal unit of the 
factor is accounted the effective economic product of any unit of 
said factor. If this method is theoretically sound and feasible in 
practice, such experimentation would give each producer informa- 
tion as to the effective economic product and hence as to the effective 
significance of the factor in question in his particular business. 



370 PRINCIPLES OF ECONOMICS [XXIX 

Whereupon, the competition of producers in different fields would 
insure that the price of that factor could not be as low as its first 
extra-marginal significance, nor above its marginal significance over 
the field of production as a whole. 

In the opinion of the writer, this method of imputation is of 
much less general applicability than its advocates seem to believe. 
A good case can be made for its feasibility only in the simpler types 
of industry, particularly, farming. Nevertheless, since such indus- 
tries utilize a very considerable portion of our store of primary 
factors, a method which can claim a considerable degree of success 
in isolating the economic product of factors in that particular field, 
surely ought not to be ignored in connection with the question we 
are now considering. 

Economic Product and Significance. — It is hardly necessary 
to say that, if by any of the methods commented upon above we 
are able to isolate the economic product of a given factor in a 
particular productive operation, we shall also be able to isolate the 
significance of said factor in that particular operation. For the 
significance of said factor would of course be the same as the 
significance of its product ; and that, we may assume, would be 
clearly expressed in the money value of that product. 

Ill 

Knowledge of Significance in the Particular Industry Insures a 
Price Expressing Significance over the Whole Field 

We have tried to show that in not a few cases the entrepreneur 
is able to ascertain in one way or another something about the 
significance or importance of a given factor in the particular indus- 
trial process in which it is operating. We have now to show that 
when this is true the natural working of competition must tend to 
establish for said factor a price which expresses its effective sig- 
nificance over the whole field. The reasoning by which this propo- 
sition is supported is plain. If the producer is able to ascertain the 
true significance of the factors in his particular operation, he will, of 
course, be ready to bid for a unit of such factor a price as high as 



XXIX] PRIMARY FACTORS AND SIGNIFICANCE 371 

one which expresses such significance. But, with such a condition 
realized, the reciprocal bidding of different entrepreneurs must cer- 
tainly keep the price from going as low as one which expresses the 
first extra-marginal significance, since this is necessary in order that 
extra-marginal buyers should be excluded. On the other hand, the 
persons who supply said factor must bid the price down to a price 
not higher than the one which expresses the marginal significance 
of said factor, since otherwise the marginal buyers would be ex- 
cluded. Accordingly, under the condition supposed, that is, the 
condition which makes significance in the particular case ascertain- 
able, the ordinary working of economic forces will tend to set the 
actual price of each factor at a point not as low as the first extra- 
marginal significance of that factor over the whole field, but, at the 
same time, not higher than its marginal significance over the whole 
field. 



CHAPTER XXX 

THE PRICES OF PRIMARY FACTORS AND 
SIGNIFICANCE (Continued) 

The method employed in the preceding chapter, in maintaining 
the doctrine that the effective significance of a primary factor over 
the whole economic field has a part in determining its price, was built 
on the assumption that it is possible, to some extent at any rate, to 
isolate the significance of such factor in particular productive opera- 
tions. The result of that argument seems to justify the claim that 
we have a strong presumption for the fairly complete dominance of 
our principle in some cases, notably that of land, and for a decided 
tendency toward such dominance in not a few other cases. I am 
not content, however, to leave the matter at this point. It seems to 
me that we have it in our power to go much further, — that we are 
able to show the presence of price-determining processes, which, 
though indirect in their action, are more important than all the 
direct ones enumerated, which processes, under the theoretically 
perfect conditions of abstract economics, would make the prices of 
all primary factors precisely the ones which express the effective 
significance of those factors, and that without the assistance of any 
of the processes which have been discussed hitherto. Further, I be- 
lieve that, even under actual conditions, this proposition has suf- 
ficient applicability to make it of great importance. This being so, 
it now becomes our duty to give this matter a full presentation. 

Conditions Assumed. — In order to make clear that the 
processes upon which this theory depends have no connection with 
those which were presented in the preceding chapter, and also to 
make the precise nature of these processes stand out in the most 
definite manner possible, I propose to start with a hypothesis where- 
in we could have no clue whatever to the significance of a factor in 

372 



XXX] PRIMARY FACTORS AND SIGNIFICANCE 373 

the particular operation in which it was being employed. That is, 
we shall start with a hypothesis under which, by assumption, there 
is no possibility of finding a case in which the factor we were study- 
ing was workmg unassisted by other economic factors ; and there 
would be no possibility of ascertaining the specific product of that 
factor by either the "surplus" method^, or the "dosing" method of 
imputation.^ I shall try to show that even under these rigorous con- 
ditions every primary factor would inevitably come to have a price 
which expressed the effective significance of that factor, — provided 
always that the fundamental conditions assumed in all price theory 
are fully reaUzed. 

I 

Each Factor in Joint Processes Has Its Specific Significance in 

Such Processes Even if That Specific Significance 

Cannot Be Ascertained 

Our first task in maintaining this thesis is to convince ourselves 
that there really exists such a specific significance attaching to each 
factor — for this proposition is not manifest on the surface. In fact, 
a case could be made for the contention that the very idea of such a 
specific significance for each factor under the conditions which we 
have assumed, is absurd. Thus, let us suppose that one unit of a 
certain commodity, which we will designate as Pi, requires for its 
production the cooperation of three factors which we will designate 
Fi, F2, Fa, respectively ; that these factors are combined in the pro- 
portion of 4Fi's, 3F2's, and iiFa's; and that there is no possibility of 
isolating some fractional part of the product as being produced by the 
4Ft's, another part as being produced by the 3F2's, and another part 
as being produced by the 11 Fa's. If, now, we assume that a unit of 
the product, P>, has a significance of 86 cents, then, obviously, the 
4Fi's, the 3F2's, and the iiFa's must together have a joint significance 
of 86 cents, since their product has that significance. But, is it not 
absurd to talk about the specific significance of the 4Fi's or that 
of the 3F2's or that of the iiFa's? Only an affirmative answer seems 



* One condition on which the dosing theory claims to be able to build 
would be retained. That condition is the possibility of using different com- 
bining proportions. 



374 PRINCIPLES OF ECONOMICS [XXX 

possible. So long as we are dealing with a single situation like the 
one supposed, the very idea that each kind of factor, the Fi's or the 
F2's or the Fa's has its own specific significance in the process, in- 
volves a logical absurdity. 

But, now, this is not the end of the matter. It is quite true that, 
with no other facts before us than those contained in the single 
proposition that the 4Fi's, 3F2's and iiFs's would together produce 
a product worth 86 cents, we could not, with propriety, speak of the 
specific significance of any one of these three factors. But, then, it 
is quite incredible that these facts should be the only ones before us. 
We should doubtless have many others at our command, else our 
complete hypothesis would be so far from reality as tO' have no 
interest for us. In particular, there would doubtless be many other 
kinds of goods beside the Pi we have supposed, which other goods 
we were producing with these same three factors, Fi, F2, and Fs ; 
and, in producing those other kinds of goods, we should, in many 
cases at least, be using combinations of the three factors different 
from the combinations used in producing Pi. It is in view of this 
change in our way of looking at the matter that we are easily able 
to show that each factor in joint processes really has its own pe- 
culiar, specific significance in the productive process. That is, we 
are easily able to show that, though the data derived from the single 
proposition concerning the production of Pi with which we started 
would not warrant our imputing specific significance to each factor, 
these data combined with data derived from other facts of the sit- 
uation, other productive operations, would dO' so — in short, if all the 
facts of the situation he taken into account, each factor in produc- 
tion has its own specific significance. 

Proof. — Let us suppose, then, that we use but three primary 
factors as above, Fi, F2, and Fa ; that we know on just what goods 
our stock of factors ought to be expended, and just what combin- 
ing proportions ought to be used ; that our productive processes are 
all direct from primary factors to consumers' products; and that 
there are at least three cases in which the proper combinations are 
different each from the others. Let these cases be as follows : 
(i) one in which 4Fi's, 3F2's, and 11 Fa's unite to produce a product. 



XXX] PRIMARY FACTORS AND SIGNIFICANCE 375 

Pi, having a value of 86 cents; (2) one in which 4Fi's, loFz's and 
2F3's unite to produce a product, P2, having a value of 60 cents; 
and (3) one in which loFi's, 3F2's, and sFs's unite to produce 
Ps, having a value of 50 cents. Now, letting x, y, and s represent 
the unknown values or importances of Fi, F2, and Fs, respectively, we 
obviously are able to derive three equations as follows: 

4-^+ 3^ + 11^ = 86 cents 

4X -\- loy -f- 22 ^ 60 cents 

lojr + 33' + 3-2 = 50 cents 

Solving these equations for the three unknowns, we get the following 
results : 

X =: 2 cents 

y ^ 4 cents 

2 =^ 6 cents 

That is, in view of the values of the products into which our factors 
must be put and of the proportion in which those factors must be 
combined, if most wisely used, each Fi has a value or significance of 
two cents, each F2 a value or significance of four cents, and each Fi 
a value or significance of six cents. 

II 

Meaning of Significance or Importance over the Whole Field 

We have seen that, under our hypothetical conditions, each factor 
in a joint productive process has its own special significance. Before 
going on to maintain that the said significance influences the price of 
said factor, we must remark on the peculiar character of the sig- 
nificance or importance which has been here affirmed of factors, that 
is, significance over the whole Held. The point needing special com- 
ment is that the term, significance, in this connection has a less con- 
crete meaning than in previous connections. Most frequently we 
have meant by the significance of an economic good a significance 
derived from the direct dependence of some gratification upon con- 
trol over specific units of that good, and which, therefore, is the same 
as the significance of that gratification. Thus, if a certain gratifica- 



376 PRINCIPLES OF ECONOMICS [XXX 

tion of one's want for fruit were dependent on possessing a par- 
ticular quart of berries, the significance of that quart of berries 
would be the significance of that particular gratification. Now, 
strictly speaking, such a conception of significance is applicable only 
to final products, consumption products ; but it could without great 
difficulty be applied to the case of a factor whenever we couldjsolate 
some particular unit of some consumption good as the specific eco- 
nomdc product of said factor. The connection in such a case would, 
indeed, be indirect, one or more stages removed. But, after all, a 
specificgratification would be dependent on the particular unit of that 
factor, and hence those particular units would have the significance 
which attached to that specific gratification. Thus, assuming that the 
quart of berries in our illustration above had but one cost, fifteen 
minutes' labor, then the significance of that labor would be the same 
as the significance of the berries, that is, the significance of the grati- 
fication derivable from those berries. 

Significance to the System. — But, now, in our present con- 
nection, such a concept of significance is too direct, too concrete 
The significance of a factor the specific product of which we are 
unable to isolate cannot be directly traced to the gratification deriva- 
ble from some particular consumers' product, because the course of 
causation between such factors and the particular consumption- 
product cannot be traced. The different factors are all thrown, 
so to speak, into a vast organic system and out of that system, viewed 
as a whole, all consumers' goods are drawn. Immediately, then, all 
goods are the product of the system ; and all the services of the fac- 
tors are services to the system. As a consequence, the significances 
of the factors must, in the first instance, be found in the system, not 
in products. In short, the significances of factors cannot be traced 
to the significances of particular units of goods. 

Significance to Concrete Persons. — These comments, how- 
ever, should not mislead us. All economic significance, whether sig- 
nificance of products or of factors, is ultimately due to the gratifica- 
tions — advantages — to be derived from such products or factors by 
living human beings, not by systems. But, since the product on 



XXX] PRIMARY FACTORS AND SIGNIFICANCE 377 

which the gratification of our wants depends necessarily comes to 
us through the system, that gratification necessarily depends on the 
proper, satisfactory ivorking of the system. Hence, significances 
which attach to the system or to the whole body of products rather 
than to specific products, are, after all, very real significances for 
each of us a>s living human beings. 

Ill 

The Spontaneous Working of Economic Forces Tends to Give 

Each Primary Factor a Price Expressing Its 

Specific Significance 

The preceding discussion has shown that, despite the fact that we 
have eliminated in our hypothesis the possibility of ascertaining 
directly the significance of factors in the particular processes in 
which they are employed, still each has its own specific significance 
over the industrial field as a whole. We must now try to show that 
each one of such factors tends to get a price which expresses this 
specific significance which we have proved must exist. ^ The argu- 
ment which we shall employ in maintaining this contention may be 
summarized in the following proposition : 

The presence on the market of an abnormal price for any pri- 
mary factor, that is a price different from one which would ex- 
press the effective significance of that factor, would, of itself, be 
sufficient to set up a series of reactions tending to replace said 
abnormal price with one which did express the effective signi- 
ficance of the factor in question ; and these reactions would not 
cease until the latter price had been established. 

In developing the line of reasoning summarized in this proposi- 
tion, our first task is to comment on the initial steps which set up the 
different series of reactions. In general, these consist of abnormal 
policies adopted by producers because of the abnormal price for some 
factor which we have assumed. Such abnormal policies have their 



* Remember that our algebraic operations were used to show merely that, 
even under our extreme hypothesis, each factor would really have its own 
specific significance. Those operations did not show that said significance 
would determine the price of said factor. This task is yet to be performed. 



378 PRINCIPLES OF ECONOMICS [XXX 

origin in the fact that the abnormal price of the factor in question 
makes abnormal (i) the comparative costs of producing different 
goods, and (2) the comparative costs of using different combining 
proportions in producing the same goods. Because of these ab- 
normalities in cost due to the assumed abnormal price of some factor, 
the policy of producers would tend to be made abnormal in a variety 
of ways. In our argument, however, we shall make use of but two of 
these, namely : ( i ) Abnormal decisions in respect to the goods to be 
produced, and (2) abnormal decisions in respect to the combining 
proportions to be used in producing those goods. 

Comparative Costs of Products Abnormal. — That an abnor- 
mal price for a given factor must alter and, therefore, must make 
abnormal, the comparative costs of producing different goods is 
almost self-evident. If, for example, the price of a given factor 
were abnormally low, though this fact would lower the cost of all 
products more or less, the effect would be greater in the case of 
those goods into which the abnormally cheap factor entered in larger 
proportions. Thus, if we suppose the third of the factors used in 
our illustration on pages 374 and 375, Fs, to have a price of 4 cents 
instead of the normal one of 6 cents, the cost of every one of our 
3 products would be lowered. Pi from 86 cents to 64 cents or 25 per 
cent; P2 from 60 cents to 56 cents or 6 per cent; and Fa from 50 
cents to 44 cents or 12 per cent. On the other hand, although an 
abnormally high price for Fs would raise costs for each of the three 
products, it would have more effect on the goods into which that 
factor entered in larger proportion. Thus, with a price of 8 cents 
for F3, the cost of Pi would be raised from 86 cents to $1.08 or 25 
per cent, the cost of P2 from 60 cents to 64 cents or 6 per cent, 
and that of Ps from 50 cents to 56 cents or 12 per cent. > 

Costs of Combining Proportions Abnormal. — But an abnormal 
price for a given factor would alter not only the comparative costs of 
producing different goods, but also the comparative costs of using 
different combining proportions in the production of the same com- 
modity. Thus, let us suppose that a combination of iFi, 1F2, and 
i4F3's would produce a unit of our commodity Pi quite as well as our 



XXXI PRIMARY FACTORS AND SIGNIFICANCE 379 

original combination of 4Fi's, 3Fa's and iiFs's. At the normal price 
for Fs's, which was assumed to be 6 cents, this new combination 
would be shut out, since its total cost would be 2 cents plus 4 cents 
plus 84 cents, or a total of 90 cents, whereas the cost of the original 
combination was only 86 cents (8 plus 12 plus 66). If, however, the 
price of one F3 should leave the normal, falling to 4 cents, the cost 
of the new combination would fall to 62 cents (2 plus 4 plus 56), 
while that of the old combination would fall to only 64 cents (8 plus 
12 plus 44). 

Comparative Profitableness Abnormal. — But it is hardly 
necessary to say that an abnormality in the price of a factor which 
lowered the comparative cost of producing a particular commodity 
or of using a particular combination would necessarily increase the 
comparative profitableness of producing that commodity or using that 
combination. Further, this process would reverse the positions of 
two products or two combinations as respects comparative profitable- 
ness wherever the conditions were such that the differences between 
the comparative costliness of different products and different pro- 
ductive combinations were slight differences, a condition which prob- 
ably obtains in the majority of cases. 

Choice of Products and Combinations Abnormal. — Finally, 
since the original abnormality in the price of one of the factors tends 
to reverse the positions of different products and different combining 
proportions in respect tO' their profitableness, it tends to reverse the 
policies of producers in respect to which of two products they will 
produce and which of two different combining proportions they will 
employ. On the one hand, an abnormally high price for a given 
factor will cause them to produce less than the normal amount of 
goods which call for a large quantity of said factor and to employ in 
less than the normal amount the particular combinations of factors 
which contain the particular factor in large quantity. On the other 
hand, an abnormally low price for a particular factor will cause 
entrepreneurs to produce more than the normal amount of the goods 
which call for a large quantity of said factor and employ to a more 
than normal extent the combinations of factors which contain this 



380 PRINCIPLES OF ECONOMICS [XXX 

particular factor in large quantity. In the former case, the reaction 
just noted, — that is, the too scanty production of goods and the too 
scanty use of combinations which call for large quantities of the 
factor in question, prepares us for the final one to appear in the 
next paragraph. In the second case, however, one more reaction 
precedes the final one. When the abnormally low price of the factor 
in question has led entrepreneurs to drain off the supplies of that 
factor to produce goods and use combinations which were profitable 
only because of said abnormally low price it becomes inevitable that 
the production of other goods which, in view of the situation as a, 
luhole, are needed more than these into which our factor is supposed 
to have gone, should fall below normal. That is, the toO' low price of 
the factor in question results in an abnormally small output of 
products having a higher importance. 

Final Reactions. — We come now to the last step in these 
reactions set up by the abnormality in the price of our primary fac- 
tor. First, what is the final reaction in the case of an abnormally 
high price for our factor? The answer is easy. Since a too high 
price for that factor inevitably results in an abnormally small produc- 
tion of those goods and an abnormally small use of those combina- 
tions in which that factor plays a large part, there comes to be on the 
market an excess of this factor, with the result that those who' supply 
said factor are obliged tO' bid down the price in order to get a market 
for their commodity. Accordingly as respects this case of an 
abnormally high price for a factor, we have reached our goal. The 
abnormality in that price inevitably sets up a series of reactions which 
tend to eliminate said abnormality : the too high price of the factor 
is bound to be its own undoing. 

What, finally, is the end of the series of reactions which results 
from an abnormally low price ? The last reaction already noted had 
brought us to an abnormally small output of various goods which 
the situation called for, but from which producers had been drawn 
off to produce goods the production of which had been made un- 
usually profitable by the abnormally low price of the factor in ques- 
tion. It is this decrease in the output of goods really called for 
which brings on the final reaction. Such decrease in the output of 



XXX] PRIMARY FACTORS AND SIGNIFICANCE 381 

these goods necessarily raises their marginal significance; this raises 
their price; such rise in price increases the profit to be earned in 
producing them; and finally entrepreneurs, as a condition of earning 
that profit, bid up the price of the factor which is too cheap. 

To sum up these reactions in a sentence we may say : On the one 
hand, an abnormally high price for any factor necessarily throws 
out of employment a greater or less quantity of that factor and sO' 
in the end tends to destroy itself; on the other hand, an abnormally 
low price for any factor shifts production from more important tO' 
less important commodities, and the reaction necessary to correct 
this misdirected production eliminates or tends to eliminate the 
abnormal price supposed to exist. 

Reactions Cease only with Price Normal. — We have seen 
that the presence of a price for a factor which did not express the 
efifective significance of that factor would, through its influence on 
the conduct of producers, set in motion reactions tending to remove 
the original cause of the trouble, the said abnormal price of said 
factor. We have only to add that these reactions could not cease till 
they had replaced the abnormal price of the factor with its normal 
one, that is, with one which expressed the efifective significance of 
said factor. This is, of course, implicit in the contention already 
maintained. Any departure from the normal price of the factor 
must tend to set up the reactions described. Doubtless a large dis- 
crepancy between the normal price and the actual price would set 
up the needed reactions more quickly and give them greater energy. 
But the existence of any discrepancy, however small, must tend to set 
up the reactions described ; and nothing would completely shut them 
out except the entire disappearance of such discrepancy. 



CHAPTER XXXI 

THE SYSTEM OF PRICES AS A WHOLE 

In the last two chapters we have tried to work out a tenable doc- 
trine as to the processes by which the prices of the most funda- 
mental elements in the economic order — the primary factors or cost- 
goods — are determined. It now becomes our duty to try to bring 
these ultimate ^ processes into relation with those more immediate 
or superficial ones which are embodied in the law of single price, the 
laws of supply and demand, the laws of cost, and so on. In other 
words, we must try to get some notion of price determination as a 
complete process, some notion of the system of prices. 



There Must Be a Coherent, Self-Consistent System of Prices 

The Interdependence of All Prices. — Perhaps the most natural 
introduction to an attempt to get a bird's-eye view of the price sys- 
tem as a whole is to make ourselves realize that there is such a sys- 
tem. Prices are not a mere aggregate of unrelated entities or only 
slightly related entities. Instead, we should realize that, in very im- 
portant senses, the prices of all goods are interdependent and must 
tend to form a coherent, self-consistent system of prices. Obviously 
this doctrine is in some degree explicit or implicit in our previous 
study of prices. Thus, in saying that the price of a wooden chair 
is determined by its cost of production, we thereby say that there 
is interdependence between the prices of products and the prices of 
the cost-goods entering into those products. Again, in affirming such 
determination of the price of the chair by its cost, we implicitly 
affirm that there is interdependence between the prices of all, products 
from one common cost-good, such as wood or steel or labor. 



* Logically ultimate. 

382 



XXXI] SYSTEM OF PRICES AS A WHOLE 383 

But, while the interdependence of prices has in some degree been 
brought out in our previous study, it has been so Httle emphasized 
that one might easily get the impression that the determination of the 
price of each commodity is a matter by itself, or anyhow that there 
is no general, all-inclusive interrelationship among prices. In an 
account of final price determination, therefore, it is important to lay 
some stress on this point. Put in a formal way, it may be stated 
as follows : 

All prices, especially the prices of produced goods, are inter- 
dependent; and equilibrium among the price-making forces can be 
approximated only when all prices have come to form a coherent, 
self-consistent system. 

Cost-Goods and Products. — As already noted, two very im- 
portant reasons for affirming the interdependence of prices are ex- 
plicit or implicit in the doctrines which make the prices of products 
coincident with their costs of production. In the first place, this very 
relationship of cost-good and product directly involves interdepend- 
ence. If two things have to be equal, there must be interdependence 
between them. This conclusion is unavoidable whatever theory we 
may hold as to the direction of causation between cost-good and 
product. If we accept the doctrine given in Chapter XXXI that, 
generally speaking, the value of the cost-goods is communicated to 
the product, the interdependence of the prices of the two types of 
goods is manifest. If we accept the doctrine which is apparently 
held by some writers that the price of the product always deter- 
mines the prices of the cost -goods, the result is the same: the two 
sets of prices must coincide, must therefore be interdependent. 

Common Intermediate Cost-Goods. — A second reason for the 
necessary interdependence of prices, derived from the principle that 
the prices of cost-goods and products must coincide, is the fact that 
many products involve the consumption of one common cost-good. 
Thus, rails, girders, saws, knives, razors, watch springs, etc., be- 
ing all made from steel, must have their prices influenced by that 
of steel and at the same rate, hence those prices must be interde- 
pendent. The price of any one of them could be determined in- 



384 PRINCIPLES OF ECONOMICS [XXXI 

dependently of the others only in case the steel used in making them 
were sold, in the same market at the same time, for different prices 
corresponding to its different uses. But such a state of things we 
have already shown, in the law of Single Price, to be impossible. 

Common Primary Cost-Goods. — But, admitting this point, 
cannot the prices of all products made from one particular kind of 
raw material be determined independently of the prices of products 
made from other kinds of raw materials f For example, though the 
prices of rails could not be determined independently of the prices 
of engines, girders, saws, planes, and knives, still the prices of all 
products made from steel could surely be determined independently 
of the prices of all products made from lead or copper or zinc or 
wood. On the contrary, this doctrine is scarcely less absurd than 
the former. Like the steel knives, steel saws, and steel girders re- 
ferred to in our first example, products made from steel and products 
made from lead, copper, and zinc also have common sources, — the 
human labor of many different kinds and the capital or carrying 
power which is required in all the industries concerned. Conse- 
quently if the prices of products made from steel were to be deter- 
mined independently of the prices of products made from lead or 
zinc or copper, then the different kinds of labor, the waiting power, 
and the other factors which constitute common sources for steel, 
lead, zinc, and copper — would each have to have many different prices 
in the same market at the same time, in contravention of the Law 
of Single Price. 

Different Goods Reciprocal Substitutes. — We have seen that 
the interdependence of the prices of many goods anyhow is assured 
because of the principle that the prices of products and cost-goods 
must coincide. Other more inclusive reasons why there must be in- 
terdependence of price grow out of the fact that different kinds of 
goods occupy toward one another the relation of reciprocal sub- 
stitutes; if there are serious obstacles to buying a particular good, 
some other can more or less completely take its place. This is con- 
spicuously true in the case of groups of goods intended to serve the 
same general purpose, such as the different means for furnishing 



XXXI] SYSTEM OF PRICES AS A WHOLE 385 

illumination, or the different foods, methods of transportation, and 
so on. As a result of such possibility of reciprocal substitution, 
the demand schedules of these different goods are interdependent, 
each one is affected by changes in the others. A change in the price 
of gas modifies the demand schedules of electric lighting, of kerosene 
oil, of candles, etc. ; a change in the price of wool modifies the de- 
mand schedule of cotton; a change in the price of meats modifies 
the demand schedules of potatoes, beans, etc. But, if the demand 
schedules of different commodities are interdependent, their prices 
must also be interdependent; since changes in their demand sched- 
ules, other things being equal, must change their prices. Interde- 
pendence of prices, therefore, follows as a result of the fungibility 
of different goods, the possibility of their reciprocal substitution. 

The particular ground of interdependence just brought out is 
most certainly present and most clearly seen in the case of groups of 
goods intended for the satisfying of the same want. But the same 
statements apply in a degree to almost all kinds of goods. In a broad 
but legitimate meaning of the language, practically all goods occupy 
toward one another the relation of reciprocal substitutes. Each is 
competing against every other for the opportunity to satisfy our 
wants. A rise in the price of any one tends to cause a change in 
the demand schedules for all or many others. Changing their demand 
schedules, it must of course tend to change their prices. Thus, 
again, all prices are interdependent.* 

A Self-Consistent System of Prices. — We have shown the 
soundness of the first part of our general proposition, which says 
that all prices are interdependent. The second part follows as an 
immediate inference from the first, and should call for no other 
argument. Since all prices are interdependent, are reciprocally de- 
termined, reactions among them cannot cease — equilibrium cannot be 
reached — till they together form a coherent, self-<consistent "whole. 



^ It is hardly necessary to warn the student that there is some danger of 
exaggerating the importance of this interdependence of prices. It would 
certainly be a serious error to imagine that the facts just brought out seriously 
impair the value of the principles of price hitherto presented. These facts 
must rather be thought of as qualitications of those principles, minor forces 
modifying their effects. 



386 PRINCIPLES OF ECONOMICS [XXXI 

Illustrative Problems 

1. It is quite unsound to imagine that the wages paid in a particular 
coal mine or in coal mining generally are determined independently 
of wages in other lines of industry. Wages are prices, and, like other 
prices, they are bound to be interdependent. Give specific reasons for 
the correctness of that statement in the case of wages. 

2. It has been held by some writers that almost any tax system, if 
only it is old enough, will fall on the different classes of citizens with 
about the same weight as would any other system raising the same amount 
of revenue. This doctrine is doubtless overstated; still it contains an 
element of truth. Give the general argument in support of it. 

3. (a) "A protective tariff is a device for taxing the consumers of 
the commodity involved in order to give big incomes to the producers of 
that commodity." 

(b) "A protective tariff is a device for taxing the consumers of the 
commodity involved in order to insure the maintenance of the industry 
which produces that commodity." 

Looked at broadly, the second statement is much nearer the truth. 
Assuming the tariff to be kept constant, there is no reason for expecting 
that the producers of the protected industry will reap exceptional profits 
therefrom. Argue in support of that statement. 

II 

Price Determination as a Complete Process 

We have seen that all prices are in greater or less degree inter- 
dependent and that they tend to form a coherent, self-consistent sys- 
tem of prices. We must now attempt to get a bird's-eye view of 
this system, — to see it as a totality, with its parts articulated. In do- 
ing this, we shall set up a series of hypotheses, the earlier ones very 
simple yet helping us to understand some aspects of the present order. 

First Hypothesis : Only One Primary Factor ; No Disutility Cost ; 

Many Products Wanted; Both Demand and Supply 

Schedules Elastic; Conditions Static 

We begin with the hypothesis that there is but one primary factor ; 
that this has no disutility cost ; that many products are wanted ; that 



XXXI] SYSTEM OF PRICES AS A WHOLE 387 

all are increasing-cost products, hence have elastic supply schedules ; 
that all demand schedules are elastic ; and that conditions in respect 
to population, tastes, methods of production, etc., are substantially- 
unchanging. 

Starting with such a hypothesis, let us suppose that the number- 
less forces at work have acted and reacted till they have brought 
about a condition of equilibrium, that is, a condition under which 
all forces have become exhausted or neutralized by opposing forces 
till there is no longer any tendency to change in the prices prevailing. 
What, now, in such a state of things will be true with respect to the 
operation of our laws of price and their relation to one another? 

All Price Laws Operative. — In the first place, it is evident 
that in such a state of equilibrium the results naturally zuorked out 
by every law of price must have been realised. The single primary 
factor and the several products must each have but one price. Sup- 
ply and demand for the single factor and for each product must have 
come to equality. The price of each product must express its mar- 
ginal significance or utility. The price of each product must equal 
its marginal cost of production. The price of the one primary factor 
must express its marginal significance in products ; and, under our 
present hypothesis of perfect elasticity in all demand schedules, this 
marginal significance will be found, not in just one or a few products, 
but in each product. 

One Law Finally Determinative. — A second and much more 
important fact of the situation would be that, though the results of 
all the laws of price would have to be realized in the state of equi- 
librium supposed, one of these and only one is finally determinative. 
The condition of single price, of supply equalling demand, of price 
coinciding with cost may be realized many times temporarily, pro- 
visionally, without final equilibrium's thereby having been reached. 
But, jiust as soon as the law that the price of the single primary factor 
must be such as expresses its marginal significance in products has 
been realized, equilibrium, final equilibrium, will have been attained. 
This condition — ^this coincidence of the price of the primary factor 
and its marginal significance — and this condition only, will establish 



388 PRINCIPLES OF ECONOMICS [XXXI 

a definitive, final, set of prices. Doubtless such a state of things can 
be reached only after there have taken place innumerable reactions 
in which other forces and other laws will have been operative. But 
the reaction bringing about this coincidence of the price of the pri- 
mary factor and its marginal significance in products will be the final 
reaction. With the coming of that price, equilibrium will have been 
reached, tendency to further change will cease. It follows that, under 
our present hypothesis, the marginal significance of products — 
viewed as the determinant of the price of the single primary factor — 
must be conceived as the ultimate determinant of the prices of prod- 
ucts. But, in interpreting this proposition, we must not fail to bear 
in mind the phrase in italics. The marginal significance of products 
is the final determinant of the prices of products only when viewed 
as the determinant of the price of the single primary factor. But the 
clearing up of this point must wait for the statement of our next 
hypothesis. 

Other Laws Subordinate. — As a complement to the point 
last made, we have to note that, under our present hypothesis, the 
principles or laws of price other than the one affirming the coincidence 
of the price of the primary factor and its marginal significance, are 
little more than instrumentalities through which said coincidence 
is established and through which the domination of the whole situa- 
tion by the marginal significance or utility of products is assured. 
The principles of single price and of supply and demand are opera- 
tive every moment, responding to every slightest change in condi- 
tions, while the final equilibrium is being worked out. The principle 
of cost lags a little behind, but only a little. Together they are in- 
suring that equilibrium cannot come till the finally determinative 
condition — the coincidence of the price of the primary factor and 
its marginal significance — is realized. 

Illustrative Problem 

"The law of single price tends to insure the domination of marginal 
significance over the entire stock of any single commodity; the laws 
of cost tend to insure such domination over the whole field— as between 
different commodities." Defend that statement. 



XXXI] SYSTEM OF PRICES AS A WHOLE 389 

Second Hypothesis : Same as Before ; but Most Demand Schedules 

Inelastic 

We now make a slight change in our hypothesis in order to bring 
out unmistakably the fact that the marginal significance of products 
was the final determinant of prices only when viewed as fixing the 
price of the primary factor. This doctrine was indeed implicit in the 
case embodied in the preceding hypothesis, and has already been 
noted. But, under that hypothesis, we could not easily make the 
point clear. As long as all demand schedules are perfectly elastic, 
the price of every product will coincide with its own marginal sig- 
nificance, so that we are in danger of fancying that the marginal 
utility of products directly determines the prices of products with- 
out reference to the marginal significance of the primary factor. In 
fact some writers who have done much to establish the correct doc- 
trine have more than once carelessly spoken as if the price of each 
product were determined by its own marginal significance only.^ 
The unsoundness of this view is easily seen when we change our 
hypothesis so as to make some of our demand schedules inelastic. 

To be quite specific, let us suppose that only two of our demand 
schedules are elastic, those of the marginal and first extra-marginal 
products; that the marginal significances, and so the marginal de- 
mand prices, of the supra-marginal products are all much above their 
marginal cost of production ; and that there are no extra-marginal 
demands for these products. Under this hypothesis, the competition 
of producers would bring the prices of all supra-marginal products 
down to their cost of production, that is, to figures below their mar- 
ginal significances. In other words, the prices of these supra-mar- 
ginal products would not even coincide with their marginal signifi- 
cances. Those marginal significances, therefore, could not be credited 
with fixing their prices. It is only the marginal significance of 
the marginal product which figures in the process. But even this is 
not the end of the matter. This highly important thing, the marginal 
significance of the marginal product, could not be determined in- 
dependently of the quantity of the primary factor available. Had 



* Writers of the Austrian school. See Note 6, Appendix, 



390 PRINCIPLES OF ECONOMICS [XXXI 

there been more of that factor, more products could have been pro- 
duced, and so the marginal significance of the marginal product would 
have been lower ; had there been less of that factor, the opposite re- 
sult would have been reached. It was possible, therefore, to reach 
final equilibrium only when the marginal significance of the marginal 
product had communicated itself to the primary factor and brought 
the price of said factor into coincidence with that significance. That 
is, as affirmed above, the real condition of final equilibrium is not 
the coincidence of the price of each product with its own marginal 
significance, but rather the coincidence of the price of the primary 
factor with its marginal significance as determined by the marginal 
significance of the marginal product. 

In order to make this rather difficult matter as definite as pos- 
sible, we may summarize the doctrine applicable to our present 
hypothesis in the four following propositions : ^ 

(i) The marginal significance of the marginal product having 
been determined, determines the price of that product;^ 

(2) The price of the marginal product having been determined, 
determines the price of each unit of the primary factor entering 
into that product; 

(3) The price of a unit of the primary factor entering into 
the marginal product having been determined, determines the price 
of all other units of that factor; and 

(4) The price of all units of the primary factor having been 
determined, determines the prices of the supra-marginal products. 

Here the logical starting point of causation is the marginal signifi- 
cance of the marginal product ; but it is such a starting point because 
it fixes the price of the primary factor, and through it of all products. 
Under our first hypothesis the case seems otherwise because the 
price of every product coincides with its own marginal significance. 
But this arises from the accidental circumstance that all products 
have perfectly elastic demand schedules. The fact that, when this 
condition is altered, final price determination still goes on without 
the necessity of any correspondence between the prices of the supra- 



* It may be worth the student's while to go over tne diagrammatic presenta- 
tion of this case in Note 7 of the Appendix. 
° See Note 8 of the Appendix. 



XXXI] SYSTEM OF PRICES AS A WHOLE 391 

marginal products and their marginal significances shows that the 
really essential thing is the coincidence of the marginal significance of 
products in general with the price of the single primary factor.^ 

Illustrative Problem 

If we ignore the influence of disutility, we have to say that, as re- 
spects the course of causation between cost-goods and products, this 
runs from the former to the latter in the case of individual products, but 
from the latter to the former in the case of products taken as a whole. 
Explain what is meant and show why it is true. 

Third Hypothesis: Same as Last with Disutility Cost Added 

Our hypothesis up to this point has involved the use of a single 
primary factor of which we have a fixed amount, or output. We 
now modify that hypothesis so as to make the supplying of the pri- 
mary factor dependent on human consent, and involving a dis- 
utility, thus giving variability to the quantity supplied. The change 
in our analysis which this change in the hypothesis makes necessary, 
is easily anticipated in view of the discussion on pages 361-363. 
The price of the primary factor must be such as expresses a signifi- 
cance at least as great as the marginal disutility involved in supplying 
that factor ; and, of course, the prices of products must be high 
enough to justify such a price for the primary factor. This does not 
mean that the price of the single primary factor is no longer coinci- 
dent with the marginal significance of its marginal product, but 
that said price must also be coincident with the marginal disutility 
of supplying said primary factor. The final condition of equilibrium 
among the price-making forces is a price for each unit of the primary 
factor which fulfils both these conditions.'' 



" An interesting variation from our last hypothesis would be one in which 
the demand schedule of even the marginal commodity was discontinuous, so 
that the marginal significance of this product was separated by a considerable 
interval from its first extra-marginal one, and at the same time it was 
separated by a considerable interval from the highest significance of the next 
possible product wanted. Under this hypothesis the decisive factor would 
be, not necessarily the marginal significance of products, but a significance 
not higher than that marginal, and not as low as the first extra-marginal one. 

' For the diagrammatic presentation of this, see Note 9 of the Appendix. 



392 



PRINCIPLES OF ECONOMICS [XXXI 



Fourth Hypothesis: the General Situation of Real Life: Many 

Factors, Some Fixed, Some Variable in Amount, Some 

Having a Disutility Cost; Some Demand Schedules 

Elastic, Some Inelastic 

The conditions of real life are, of course, vastly m.ore complicated 
than any of our previous hypotheses — quite too complicated, doubt- 
less, to permit a really adequate statement of the processes of final 
price determination under those conditions. Nevertheless, it may 
perhaps be worth while to summarize in a general statement the ac- 
count of this matter which naturally follows from the doctrines with 
respect to the prices of primary factors which were laid down in 
Chapters XXVHI to XXX, and from the conclusions reached for 
the highly simplified hypotheses which we have just considered. 

Summary. — Supposing static conditions and the perfect free- 
dom of competition postulated in economic theory to be realized, 
equilibrium — disappearance of all tendency to further change — can 
come only, and then must come, when the price of each primary 
factor is brought into substantial coincidence with a significance not 
higher than its marginal one and not as low as its first extra-marginal 
one, and, if said factor involves a disutility, into coincidence with 
a disutility as great as the marginal disutility of supplying said pri- 
mary factor and not as great as the first extra-marginal one. When 
that equilibrium is reached, the price of each product having a per- 
fectly elastic demand and supply schedule will be one which ex- 
presses its marginal significance and equals its marginal cost; the 
price of each product having an elastic supply schedule but an in- 
elastic demand schedule will be one which equals its marginal cost 
and is likely to be one which is below its marginal significance, 
though it may coincide with that significance; and the price of each 
constant-cost product must be one which equals its cost of produc- 
tion and coincides with its marginal significance, if at all, only 
because that significance adjusts itself to a price determined by cost. 



CHAPTER XXXII 

PRINCIPLES GOVERNING THE MONEY STANDARD 

The preceding chapter brought to a conclusion our discussion of 
that broad division of Economics known as Exchange. Before finally 
dismissing this subject, however, we shall find it useful to give some 
further attention to the study of Money. Money, as we know, is 
the medium of exchange; and as preliminary to the treatment of 
exchange, we set forth in Chapter XIV some of the more simple 
and obvious truths concerning Money. But now, with a thorough 
study of Exchange as a whole behind us, it becomes possible, as also 
necessary and proper, to make a deeper investigation of the medium 
by which it is conducted, and to present the more essential principles 
governing that medium. In this chapter we take up the principles 
governing the money standard. 

The monetary standard, the student will remember, is that some- 
thing which fixes the significance or value of the money unit. Thus in 
the United States, 25.8 grains of gold, nine-tenths fine, fixes the value 
of the dollar; — whatever value may at any time attach to 25.8 grains 
of gold, that same value will attach to one dollar. Now this very 
definition shows that the monetary standard is, in an important sense, 
the foundation of the whole system, and that a change from one 
standard to another, or even mere liability to change, may carry 
with it the threat of serious harm. Further, experience has shown 
that it is by no means an easy task to insure that such changes will 
not take place. The monetary standard has many times been dis- 
placed in spite of the utmost preventive efforts a government could 
make; and, in fact, governments themselves have more than once 
through mistaken legislation inadvertently brought about the very 
displacement which they were trying to avoid. Manifestly, then, 
it is quite important that we should know the natural laws which con- 
cern the monetary standard in order that we may be able rightly to 
manage that standard. 

393 



394 PRINCIPLES OF ECONOMICS [XXXII 

These principles may be grouped in two classes: (i) those 
concerned with the immediate standard, standard money, which di- 
rectly, immediately, fixes the value of the money unit, and (2) those 
concerned with the ultimate standard or the something which fixes 
the value of standard money itself, iand, in doing so, finally fixes the 
value of the money unit.^ 

I 

Defining and Determining Standard Money 

The first principle to be laid down with respect to standard 
money is the following : 

Principle I. The standard money of any system must 
be a money which is at par and zvhich has its value fixed 
independently of its relations to other moneys. 

The proposition that standard money must be a money which is 
at par is hardly more than a corollary from the definition of standard 
money. 

Standard money is the immediate standard of the system, 
the money which immediately determines what the money unit is 
worth. To it, the money unit is anchored. Its value is the value 
given to the unit. But, plainly, we cannot say of a given money that 
it fixes the value of the money unit unless a unit of that money has 
the same value as the money unit it is said to fix. Thus we cannot 
regard gold coin as the standard money of the United States if we 
find that ten-dollar gold pieces are worth eleven dollars each; for, 
in that situation, some other money worth ten-elevenths as much 
as gold must really be fixing the value of one dollar. No money 
which has a value above or below the value of the unit can be fixing 
the value of that unit. 

We have just seen that the standard money must be one which is 
at par. But we commonly find two or more moneys fulfilling this 
condition, — and which one of the money at par will then be standard? 
This question is answered by the second part of our principle. The 



^ See pages 165, 166. 



XXXII] THE MONEY STANDARD 395 

standard money is that one of the par moneys which has its value 
fixed independently of the other moneys. In most cases the sound- 
ness of this contention is evident enough. Thus, in our system, gold 
coin is firmly anchored to the metal contained in it, — has its value 
fi>?ed by that metal quite without regard to the values of the other 
moneys. On the other hand, the values of treasury notes, bank 
notes, and small silver have no sort of relation to the value of the 
material in them, but are kept equal to that of gold coin by being 
made directly or indirectly exchangeable for gold coin. Manifestly, 
then, as between gold coin and the other moneys named, the former 
is the standard : it is the thing which determines; they are things 
which are determined. 

The case of a par money which is not kept either directly or in- 
directly convertible with gold coin is not so plain ; but the conclusion 
must be the same. Such a case is illustrated in most countries by 
small silver which is not redeemable,- and, in this country, by silver 
dollars. No institution is bound to redeem these coins in gold or 
its equivalent.^ Further,' the metal in the coins is much less valuable 
than gold coin, and is changing in value, as measured in gold, every 
day. 

Yet all the time these silver coins remain just equal in value to 
gold coin. Just why they do so is a problem with which we are not 
here concerned. Here we are asking: Which of these two is 
standard money ? Which is principal and which subordinate ? Which 
determines and which is determined? Surely there can be but one 
answer. The gold coin is fixed in its position, being anchored to 
the metal it contains, while the silver coin, showing no constant 
relation to the metal in it, is free to move. Hence, unless their 
equality of value is to be attributed to mere coincidence, and surely 
this is out of the question, we must conclude that the value of the 
silver coin adjusts itself to that of the gold coin, — is determined by 
that of the gold coin. Gold coin, therefore, the money which has 
its value independently determined, is established as the standard 
money. 



* It is redeemable in this country. 

' The United States Treasury would probably undertake to do so, if they 
became less valuable than gold. 



396 PRINCIPLES OF ECONOMICS [XXXII 

Illustrative Problems 

1. In the United States in 1870, gold coin was worth $1.21 per dol- 
lar, silver coin $1.23 per dollar, and greenbacks $1.00 per dollar. Which, 
if any, must have been standard money? 

2. For several weeks during the panic of 1837 coined money, whether 
silver or gold, was at a premium of from 2 to 4 per cent, while bank 
notes were at par. Which, if any, must have been standard money? 

3. Add to the first problem that in 1870 national bank notes were 
worth $1.00 per dollar and were redeemable in greenbacks. Which 
money, under this condition, must have been standard money? 

4. Supposing that all kinds of money are at a premium, only bank 
credit in the form of checks being at par, what then would be standard 
money or the immediate standard? 

Our first principle has given us little more than a rule for 
recognidng standard money. The second gives us one of the most 
important laws determining what particular money occupies .this 
place. 

Principle II. // among those moneys in any system 
which are a valid tender in the payment of debts, differ- 
ences of exchange value arise, the cheapest of such valid 
tender moneys establishes itself as the standard money, and 
the rest go to a premium. 

A good illustration of this principle is found in the monetary 
history of 1870. At that time paper money, gold coin, and silver coin 
showed differences in value, measured in paper, as follows : Gold 
was worth 21 cents more than paper, and silver was worth 2 cents 
more than gold. These dififerences could have manifested them- 
selves in any one of at least three ways : ( i ) paper might have been 
quoted at $1, gold at $1.21, and silver at $1.23, or (2) gold might 
have been quoted at $1, silver at $1.02, and paper at $.82; or (3) 
silver might have been quoted at $1, gold at $.98 and paper at $.81. 
If the first hypothesis had been realized, it can be seen by reference 
to Principle I that paper would have been the standard money; if, 



XXXII] THE MONEY STANDARD 397 

instead, the second hypothesis had been realized, gold would have 
been the standard money; finally, if the third hypothesis had been 
realized, silver would have occupied the place of honor. In fact, 
the first hypothesis was realized ; and the natural law which insured 
that it would be is the one stated in our second principle. The 
cheapest of these legal tenders was bound to establish itself against 
the rest. 

The proof of this principle is relatively simple. By hypothesis 
all the moneys in question are valid tenders for debts. Under that 
condition which will be the standard money for debts? If I have 
a right to pay my debts with either of two moneys, one of which 
is worth three cents more than the other, which will I naturally 
choose? The cheaper, of course. And what I would naturally do, 
experience proves that debtors generally do. It follows then that 
the cheapest of two or more valid tenders will be the standard money 
of debts. 

Secondly, for the sake of convenience in business transactions 
the standard money of debts and that of prices must, if possible, be 
the same. One can imagine the inexpediency of having in business 
one meaning for the dollar in debts, and another for the dollar in 
prices. A grocer fixing the prices of his goods in one kind of 
dollar, while his note to the jobber was in another sort of dollar, 
would meet serious inconveniences ; so he surely would not conduct 
business in this way unless obliged to. But, thirdly, he will not be 
obliged to do this, because the standard money for debts and the 
standard money for prices naturally draw together and become one. 
The standard money of debts is fixed by natural law as the cheapest 
of all the valid tenders, and this result men cannot change, save 
under very exceptional circumstances. But the standard money of 
prices, on the other hand, is determined wholly by the choice of the 
individual dealer. He may freely rate his goods in gold dollars or 
silver dollars, or greenback dollars, or even pounds or marks if he 
desires. It is accordingly possible for the standard money of 
prices to adjust itself to the standard money of debts ; and since, 
as we have already seen, such an adjustment is for business reasons 
highly desirable, it will inevitably be brought about. In a word, the 
cheapest of the valid tenders becomes not only the standard for 



398 PRINCIPLES OF ECONOMICS [XXXII 

debts but also the standard for prices — ^the standard money in 
general. 

Three special applications of the principle just established give 
us three corollaries of that principle which have played a part of 
very great importance in the monetary history of modern times. 
Those corollaries are as follows : 

Corollary i. // two metallic moneys are freely coined 
and full legal tender at a coinage raiio different from the 
market ratio, the money coined from the overrated metal 
will establish itself as the standard money. 

Corollary 2. If, in the case of a legal tender circulating 
note zvhich has hitherto been kept redeemable in zvhat has 
hitherto been standard money, a suspension of payments 
takes place, such legal tender note will almost certainly estab- 
lish itself as standard money. 

Corollary 3. // any form of credit m^oney or m,oney 
substitute ceases to be redeemable in standard money or its 
equivalent, and, though not a true legal tender, is made in 
effect a valid tender in payment of debts by any set of cir- 
cumstances, such money or money substitute will for the 
time being usurp the place of standard money. 

To illustrate the first of these corollaries, suppose that, when 
I ounce of gold is worth on the market 16 ounces of silver, the 
government mint treats i ounce of gold as worth only 15 ounces 
of silver, putting into each silver coin less metal than is needed, 
considering the market value of the two metals. The mint thus 
treats silver as worth more than it really is; in technical language, 
it overrates silver. Under these conditions, each silver coin will be 
worth less — it will be cheaper money — than the corresponding gold 
coin. Hence it follows from Principle II that the silver coin will 
assume the place of standard money. 

The second corollary, relating to the behavior of legal tender 
circulating notes, offers no serious difficulty. So long as such notes 



XXXII] THE MONEY STANDARD 399 

are kept redeemable in standard money, they of course will be 
worth as much as standard money. When, however, the issuer of 
the notes suspends payment on them, their value inevitably declines, 
because, although people may expect them to be again made re- 
deemable at some future time, they are not willing to give as much 
for a probable future payment as for a certain present one. But 
when notes with the faculty of legal tender become less valuable 
than the money which has hitherto been standard money, this fact 
brings into operation Principle II, — that is, these notes displace the 
money hitherto standard, and themselves usurp its office. 

The circumstance alluded to in the third corollary has repeatedly 
arisen in our history when a concerted suspension of payment on 
their notes by practically all banks has led the general public by 
tacit consent to treat those notes as a valid tender for debts. As a 
result, the notes behaved as if they were a true legal tender — in other 
words. Corollary 2 was brought into operation. 

In a similar way, bank credit, deposit currency, as it is often 
called, has more than once been made the standard money by a 
concerted refusal of banks to pay in any form of money. At such 
times, the public has come to accept bank credit as a valid tender 
for debts, thus making bank credit the immediate standard, while 
all forms of money proper went to a premium. 

Illustrative Problems 

1. In the United States in 1830, both silver and gold were freely 
coined at a ratio of 15 to i, when the market ratio was 15.8 to i. 

(a) Which metal did the mint overrate ? Explain carefully. 

(b) Which of the two moneys, if any, must have been standard 
money ? 

2. In 1830 France had a system similar tc ours but its ratio was 
iS-5 to I. 

Answer the same questions for it as for the United States under i. 

3. Why did the United States have the greenback as its standard 
money between 1862 and 1879? 

4. In 1717 the British government decreed that a gold guinea should 
be treated as the equivalent of 21 silver shillings; though, judged by the 



400 PRINCIPLES OF ECONOMICS [XXXII 

bullion in them, the guinea was worth 205^ shillings. Which must have 
become standard money ? Explain. 

5. In the panic weeks of 1837, bank notes were the standard money. 
(See Problem 2, page 396.) How do you explain it? 

II 

Defining and Determining the Ultimate Standard 

Thus far our discussion has been concerned with standard money 
and the laws governing it. Two other principles of considerable 
importance have to do with defining and determining the ultimate 
standard. The first of these is the following: 

Principle III. // by any process whatsoever the 
standard money is kept constantly equal in value to a definite 
quantity of some outside commodity or group of commodi- 
ties, such commodity or group of cotnmodities constitutes 
the ultimate standard of the system. 

This principle can perhaps be best illustrated by imagining a 
system in which there was no metallic money, some kind of paper- 
money being the standard money, but in which that paper money was 
all the time kept equal in value to a certain amount of gold or silver 
or some other outside substance. In such a system, the principle 
tells us, the gold or silver or other outside substance to which the 
standard money was kept equal in value would constitute the ulti- 
mate standard. 

As a matter of fact, this particular method of realizing the 
condition indicated in our principle is not actually employed, though 
some very able economists have favored it. The plan generally 
pursued is to have, as our standard money, coins made of the very 
metal which we wish to use for our standard, in our own case, gold. 
These coins we keep equal in value to the quantity of gold (25.8 
grains) desired for our ultimate standard by maintaining two condi- 
tions which insure this result: (i) the metal gold has free and 
gratuitous coinage — the mint must turn into coin of full weight 
without substantial charge whatever gold is ofifered; and (2) under 



I 



XXXII] THE MONEY STANDARD 401 

ordinary conditions, free melting of gold coin is permitted. When 
these conditions are reahzed, it is plainly impossible that the coin 
and the metal, being practically interconvertible, should have differ- 
ent values. No one would give more for the coin than for the metal, 
since he could have that metal turned into coin without charge ; so he 
would not give more for the metal than for the coin, since he could 
at will turn the coin into the metal by melting it. 

In the above illustration of our principle, we supposed that a 
certain amount of gold was chosen as the ultimate standard. But, 
of course, some other metal, for example silver, may be chosen, or 
something not a metal, say, wheat, or a group of things made up 
of many items : a ton of coal plus 10 yards of cotton plus 100 pounds 
of flour, etc. A standard of the latter sort has been advocated 
by many able men and is commonly known as a multiple standard. 
But, whatever the particular thing or things chosen, the idea is the 
same: if there is something outside the standard money which fixes 
the value of that standard money, that something is the ultimate 
standard. 

The principle needs little argument to establish its truth, since 
it is little more than the corollary from the definition of the ultimate 
standard. The ultimate standard is the something behind the im- 
mediate standard, standard money, which finally determines the 
value of that money, jUst as that standard money determines the 
value of the money unit. Now, it can hardly be doubted that the 
gold or silver or wheat or list of goods used in our illustrations 
answers to this definition of the ultimate standard. First, by hypoth- 
esis, the standard money is kept equal to such gold or silver or 
wheat ; and so, the latter is, in some sense, standard. Secondly, 
since this gold or silver or wheat is not, in turn, dependent on some- 
thing else for its value, such gold or silver or wheat constitutes the 
final, ultimate, standard. 

Perhaps a doubt may still linger in the student's mind. "It is 
plain that the value of our standard money, gold coin, and the value 
of the gold metal in that coin are equal. But are we sure that the 
value of the metal fixes the value of the coin rather than the reverse? 
Surely, gold as a metal has its value influenced by the value of the 
gold money." The last statement is no doubt correct: the value 



402 PRINCIPLES OF ECONOMICS [XXXII 

of money influences that of the metal just as truly as the value of 
the metal influences that of the money. Nevertheless, one of these, 
the metal, must be looked on as, in the more ultimate sense, a de- 
terminant. The gold coin of any one country constitutes only a 
small fraction of the total gold coin of the world, and a still smaller 
fraction of the total gold metal — coin, articles made of gold and 
gold bullion. Conditions tending to bring about a change in the 
money of a particular country independently of the gold stock of 
the world must, of course, tend to exercise some influence on the 
value of that gold stock. But, after all, the small fraction cannot 
be credited with determining the value of the whole. The total 
gold stock must have a value resulting from the action of number- 
less other forces as well as the causes which influence the value of 
the money of a single country; and, to the value of the total gold 
stock as thus determined, the value of the gold coin of any par- 
ticular country must tend to gravitate. As long as the money unit 
of a country is kept equal in value to a certain quantity of the metal 
gold, that metal must be recognized as the truly ultimate standard. 

Illustrative Problems 

1. A few years ago, the United States remodeled the monetary sys- 
tem of the Philippines, making silver pesos coined only for the govern- 
ment the standard money, but providing that gold exchange on New 
York should be sold to any person wanting it in exchange for silver 
pesos at a rate of $i for two pesos. Such a system tended to establish 
what ultimate money standard in the Philippines? 

2. Great Britain puts into every sovereign 113 grains of pure gold, 
coins these sovereigns for everyone free of charge, and does not attempt 
to hinder the melting of coins. Under these conditions what necessarily 
becomes the ultimate standard of Great Britain? Explain fully. 

3. What must have been the ultimate standard of the United States 
in 1830? See Problem i, page 399. 

4. What must have been the ultimate standard of France at the same 
date? See Problem 2, same page. 

Our second principle with respect to the ultimate standard has 
to do with a situation where the standard money is itself the ultimate 



XXXII] THE MONEY STANDARD 403 

standard. Prior to 1893 British India had as its ultimate money 
standard 180 grains of silver; that is, the unit coin, the rupee, 
contained 180 grains of silver and v^as freely coined, thus making 
the metal itself the ultimate determinant of the value of the rupee. 
But, in the year named, the government stopped the free coinage 
of silver v^ith the result that coins rose in value as compared with 
the metal in them, fluctuating from 32 cents down towards, but 
never to, their bullion value, 22 cents. Thus the silver rupee had 
nothing behind it to fix its value — it moved up and down inde- 
pendently of anything else. Accordingly, the silver rupee fixed 
the value of the unit (the rupee) not only immediately but also 
ultimately; and hence was itself the ultimate standard. This illustra- 
tion alone would seem to furnish sufficient proof of the following 
principle : 

Principle IV. // the standard money is not kept con- 
stantly equal in value to a fixed quantity of some commodity 
or group of commodities outside itself, but varies in value 
independently of the variations of any other object, then 
such standard money is itself the ultimate standard of the 
system. 

Illustrative Problems 

1. What was the ultimate standard of the United States between 
1862 and 1879? Explain. 

2. What was the ultimate standard of the United States during the 
panic weeks of 1837? See Problem 2, page 396. 

3. Suppose that after 1893 the government of British India had so 
managed things as to keep gold exchange on London constantly at 20 
rupees for i sovereign (123.27 grains of gold). What would then have 
been practically the ultimate standard of India? 



CHAPTER XXXIII 

PRINCIPLES GOVERNING THE CIRCULATION OF 

MONEY 

The second group of principles under our present subject con- 
cern the circulation of money — the capacity of money to form a 
part of the monetary stock, the active medium of exchange. Will 
a particular money circulate at all? What kinds of money have 
the greater capacity for circulating — ^the greater tenacity in circula- 
tion ? To v^hat part of the circulation is a particular kind of money 
Hkely to gravitate ? Will it tend to be used in the ordinary business 
of exchanging commodities or will it more probably lie most of the 
time in the banks, serving the purpose of a reserve fund ? 

These and other related questions are of importance because a 
government may in one case find it desirable to keep a particular 
money in circulation ; or in another case to drive a particular money 
out of circulation; or in still another to keep a particular kind of 
money down to a small stock, though not driving it out altogether ; 
or again to segregate a particular kind of money in some special 
part of the system. A government may, I say, at some time desire 
to do any of these things ; but it can no more accomplish its desire 
by merely decreeing such a result than it can bridge a river by that 
process. The circulation of money is ruled by natural laws; and 
a government can accomplish its objects in that field only by estab- 
lishing such conditions that the natural laws which rule the cir- 
culation will automatically work out the results desired. It is of 
prime importance, therefore, that we should be familiar with the 
more influential of these natural laws. 

The first principle which we shall lay down runs as follows: 

Principle I. Under modern conditions, the full and 
continuous circulation of any kind of money in almost any 

404 



XXXIII] THE CIRCULATION OF MONEY 405 

country of high commercial development requires a measure 
of legal authorization from the government of that country. 

The most decisive proof of this principle is to be found in the 
fact that, in all but very exceptional cases, the circulation of a 
money is limited to the country where it is legally authorized. Even 
nations lying geographically side by side, closely connected in in- 
dustry and commerce and using the same monetary standard and 
the same system of denominations, — even such nations do not usually 
circulate each other's money save along the border. Thus, despite 
the proximity and the intimate relations of Canada and the United 
States, Canadian money has no currency in this country outside 
Detroit, Buffalo, and a few other similarly situated places. 

This connection between the circulation of a money and its 
legal authorization by the home government is, of course, no mere 
accident. From early times governments have been wont to issue 
the money of their respective countries ; so that now, habit, if nothing 
more, would make the public chary of accepting any medium of 
exchange not authorized by government. Further, authorization 
by a government creates a presumption that that government will 
make some effort to insure the goodness of the money authorized. 
Such moneys, therefore, will naturally be more readily accepted 
in ordinary transactions than money which has nothing but private 
backing. Again, as between a money authorized by one's own 
government and one authorized by the government of some other 
country, men will naturally have more confidence in that authorized 
by their own. Finally, the government itself will usually discrim- 
inate against foreign moneys in certain relations, for example, in 
determining what shall be receivable for public dues or what shall 
be a legal tender for debts. This public discrimination will exercise 
more or less compulsion on private persons to take a similar attitude. 

We have seen that the power of a money to circulate usually 
depends on some degree of governmental recognition. Our next 
principle puts this case somewhat more strongly. 

Principle II. Under modern conditions, the power of 
any money to hold its place in the circulation in the fullest 



4o6 PRINCIPLES OF ECONOMICS [XXXIII 

sense varies as'^ the extent to which it is given power to do 
the different kinds of money work. 

Thus, a money which will not be accepted by the government 
in payment of taxes or which cannot be used as bank reserves will 
have less tenacity in circulation than a money which enjoys these 
prerogatives. In part, evidently, the capacity of a money to circu- 
late depends upon the willingness of people to accept it in return 
for commodities and services. But some persons, anyhow, will need 
to use a part of the money, received in exchange for their goods, 
for the purposes indicated, — to pay taxes and maintain reserves. 
They will, therefore, hesitate to accept, or perhaps absolutely refuse 
to accept, money which cannot be ultilized for these purposes. 
Further, if the money is one which they are not really free to reject 
in trade, they may yet be free, as in the case of the circulating notes 
of a bank, to return it to the issuer, getting in exchange some money 
which possesses the prerogatives lacking in the one in question. 
This course they are likely to take, and, in so doing, they put such 
money out of circulation. 

An obvious inference from the principle is that, if we wish to 
diminish the tenacity in circulation of any money, we can usually 
do so by depriving it of some prerogative ; ^ — refusing to receive it 
for taxes, forbidding its use as bank reserves, or prohibiting bankers 
who receive it from paying it out over the counter. 

The two principles j'ust set forth affirm that moneys of superior 
quality— those having recognition by the government and possessing 
all money prerogatives — remain more persistently in circulation than 
inferior moneys. We have now to remark on a principle which 
seems almost in flat contradiction of these. It affirms that inferior 
moneys have greater power in circulation. The formula "bad money 
drives out good," commonly known as Gresham's Law, is the one 
most in vogue. As thus stated, the doctrine was always inexact; 



^ Remember that in Economics "to vary directly as" means only to vary 
in the same direction, not proportionately, and "to vary inversely as" means 
only to vary in the opposite direction, not proportionately. 

^ This must be qualified by a consideration of the principle about to be 
commented upon. 



XXXIII] THE CIRCULATION OF MONEY 407 

and, however stated, it is now true to a much smaller degree than 
in earlier times. Perhaps the facts are fairly well covered in the 
following : 

Principle III. Moneys which are inferior in respect to 
exchange or substance value commonly show greater tenacity 
in circulation than those which arc superior in these respects. 

The truth of this principle has been amply confirmed in mone- 
tary history, — in fact, the principle is one of the few in economic 
science which have been accepted primarily as inductions from ex- 
perience. Its explanation is easily found in the causes at work. 
The chief of these causes is the fact that, in the circulation proper — 
the use of money in actual exchange transactions — the superiority or 
inferiority of different kinds of moneys shows relatively little ; 
whereas in various other uses, less strictly belonging to the circula- 
tion proper, or even quite outside the field of money, the superiority 
or inferiority shows relatively much. 

Take first the case of standard metallic money, — gold coin in 
our system. Coins short in weight have no difficulty passing in 
trade. Only a careful test would prove that they are actually short; 
and this test few people in the hurry of business care to make. 
Further, most people assume that, even if a coin is really short, 
no trouble will be experienced in passing it on to someone else. 
In active circulation, then, inferior coins serve as well as any. But 
not so in other relations. If a jeweler wishes to melt a gold coin 
to get the metal for use in this trade, he naturally chooses a ten- 
dollar piece of full weight, 258 grains, rather than one weighing 
somewhat less, say, 240 grains. The same is of course true of the 
exchange dealer who has occasion to send gold abroad in covering 
his drafts. Again, the peculiar position of the banker strengthens 
in another way the tendency of short- weight coins to stay in circula- 
tion. Governments and other institutions to which the banker makes 
payments will discriminate against inferior coins, so that, to save 
himself a loss, he must refuse to receive them except at a discount. 
But depositors, in turn, anxious to escape this discount, studiously 
avoid presenting such coins for deposit, — instead, keeping them for 



4o8 PRINCIPLES OF ECONOMICS [XXXIII 

their own use" in trade, while they take to the bank full weight coin 
or other par money. 

The illustration just used concerns standard metallic moneys 
which show differences in substance value as well as in exchange 
value. But paper moneys, which differ in exchange value only, 
submit easily to the same principle. Thus, prior to 1863, the bank 
notes of this country issued by all sorts of institutions and under 
all sorts of conditions, circulated at different values measured in 
standard money, some worth 100 cents on the dollar, some worth 
95, some 92, some 97. Of these notes the best ones usually showed 
less capacity to hold their place in the circulation than the inferior 
ones. Their acceptability in ordinary trade was not, indeed, as good 
as that of gold coin which was only a little inferior in weight. But, 
assisted by the ignorance of people in general, by the indisposition 
of tradesmen to displease customers by challenging money offered for 
goods, and by the anxiety of workingmen to keep their jobs, anyone 
who held such money could easily pass it on at a value greater than 
that recognized by banks and other dealers in exchange. 

On the other hand, the inferior notes were received at banks 
and public institutions only at a full discount. Accordingly, they 
were not taken in for deposit, but were sorted out for use in trade, 
while notes of the better grades went in. Further, the institutions 
in question, desiring to make room for their own notes, and to 
accumulate only moneys which would be useful as reserves, made 
a practice of sending home for redemption all the foreign notes 
they received ; hence, the fact that the ones they received were 
chiefly the better ones, resulted directly in driving these better ones 
out of circulation. Thus, there were at work not only forces tend- 
ing to choose the inferior moneys for the circulation proper, but 
also forces tending positively to drive the superior out. 

It perhaps ought to be added that even when the inferiority or 
superiority among moneys is not openly recognized, though ad- 
mitted by the. initiated, the inferior is likely to show a stronger 
hold on the circulation. Banking institutions being, as we have 
seen, in a position to discriminate by paying over the counter the 
less desirable forms of money and retaining for reserves the more 
desirable, can and do keep the former in more active circulation. 



XXXIII] THE CIRCULATION OF MONEY 



409 



The points made in the foregoing discussion apply in large 
measure to all kinds of money. The considerations now to be 
brought forward concern only credit money. Credit money, for 
example, a bank note, is simply a promise of the issuer to pay upon 
demand a stated sum of standard money or its equivalent; and 
such money is, by return to the issuer, retired from circulation. 
Accordingly, the degree to which such a money is able to maintain 
its hold on the circulation depends on the strength of the tendency 
to send it home. This in turn depends chiefly on two conditions : 
(i) the strength of the motive for returning it, and (2) the ease 
with which the operation can be carried out. As respects the first, 
if a bank note or other credit money is qualified to perform all the 
functions which the standard money that it calls for can perform, 
there will be little, if any, reason for sending it home. If, however, 
it is not receivable for public dues or is not a legal tender for 
ordinary debts, there will be some holders, anyhow, who have ample 
motive for sending it in to be exchanged for money more adequate 
for their purposes. 

The working of the second condition on which depends the 
strength of the tendency to send credit money home — the ease with 
which the operation can be carried out — may be seen from an 
imaginary illustration. If a noteholder lives in Boston while the 
issuing bank is located in Butte, Montana, and the noteholder has 
no way of securing redemption except by sending the note from 
Boston tQ Butte and bringing back the money at his own expense, 
there will probably be little of such sending undertaken. In such 
case, even though the note is not usable for the payment of taxes, 
the holder will content himself with retaining it for use in ordinary 
business. Thus, such notes tend to continue in circulation rather 
than go out by return to the issuer. They have tenacity in circula- 
tion just because there is difficulty in sending them home. 

Although the conclusion just reached was based merely on a 
consideration of the causes at work, its soundness has been fully 
confirmed in the history of bank note issues. Thus, in the United 
States in the early part of the last century, when the provisions for 
securing the "homing" of notes were quite inadequate, those notes 
which could be returned only at considerable trouble and expense 



4IO PRINCIPLES OF ECONOMICS IXXXIII 

almost completely monopolized the circulation as against notes which 
could easily be returned. This was conspicuously illustrated in the 
city of Boston as between the notes of outlying towns and those 
of Boston itself, — the latter being largely driven out by the former. 
The condition was remedied by providing for the redemption at 
par in Boston of the outside notes, and establishing an arrangement 
whereby the institution which performed this task became in eflfect 
a clearing-house for these notes. 

Under the complicated conditions of modern business, the money 
stock of a country naturally distributes itself, or is consciously 
distributed, into different parts called funds, each of which has a 
special function. Thus, a very considerable part of the stock is used 
as a medium of exchange in ordinary business. A second large 
quantity constitutes the reserves of the banks, especially those out- 
side of New York City. The New York bank reserves constitute 
a third fund, distinct from ordinary bank reserves because, for 
reasons too complicated for review in this place, the general bank- 
ing reserves of the country largely rest upon it. This fund also 
requires differentiation because it is the chief source from which 
must come the money employed in the settling of international 
balances. Another very significant fund is the 150 millions of gold 
reserved by law in the Federal Treasury for the redemption of 
treasury notes. Under the Federal Reserve system adopted a few 
years ago, the reserves of the so-called regional banks ought perhaps 
to be treated as constituting still another special fund. 

Now, it is a matter of some consequence that the proper sort 
of money and that sort only should find its way into each par- 
ticular fund; and the government takes pains so to manage the 
issue of different kinds of money that, as far as possible, proper 
distribution will be automatically effected. The result is largely 
brought about by issuing just the right denominations of the money 
which is meant for a given fund and for the appointed uses of that 
fund. 

Thus, if it is desired to keep a certain type of money out of 
banking reserves, especially out of the New York reserve, this is 
accomplished by putting out the money in small denominations. ■ The 



XXXIII] THE CIRCULATION OF MONEY 411 

principle which furnishes the basis for such a policy may be stated 
as follows : 

Principle IV. In the distribution of the monetary 
stock of a country, money of smaller denominations naturally 
gravitates to the Circulation Proper, the part which is being 
used directly as a medium of exchange ; moneys of larger 
denominations gravitate to the Reserves, the funds kept 
by banks and other institutions to meet credit obligations. 

This principle has been utilized in the practical management 
of our silver certificates, and so may be said to have been estab- 
lished inductively. But it naturally results from the conditions and 
forces present. There is comparatively little need for money of 
large denominations in ordinary transactions, since persons engaged 
in those transactions usually pay by means of checks. If, then, we 
restrict the issue of any kind of money to large denominations, we 
are certain to keep the greater part of it out of the ordinary circula- 
tion. On the other hand, in the ordinary transactions of the market 
there is much need for small money, whether in effecting payments 
outright or in making change. In consequence, we can easily infer 
that money of very small denominations will remain in ordinary 
circulation and will stay out of the bank reserves, unless it is 
issued in greatly excessive amounts. As a matter of fact, experi- 
ence shows that it is extremely difficult to satisfy the everyday 
need for money of small denominations. The government of the 
United States has been obliged over and over again to expand its 
issue of fractional silver and of small bills from $1 to $5. 

Illustrative Problems 

1. In 1849, when the United States had free coinage of both gold 
and silver, a change in the relative values of the two metals sent silver 
coin to a premium, i.e., two silver half-dollars were worth $1.02. What 
naturally happened to silver coin? 

2. During the Civil War, the government of the United States 
thought best to borrow money by paying soldiers, contractors, et at., 
with treasury notes. Yet it was desirous that these notes should not be 



412 PRINCIPLES OF ECONOMICS [XXXIII 

added to the circulating medium, but should soon get into the hands of 
people who would lay them one side and hold them till they were due, 
— in other words, treat them as bonds. The Treasury finally hit on a 
pretty good plan to accomplish this, namely, the issuing of these notes to 
bear interest, that interest to be compounded every six months but to 
be paid only at the end of three years. How would this plan tend to 
accomplish the end sought? 

3. In 1862, when gold payment on treasury notes had already been 
suspended, the United States began the issue of legal tender notes. In 
consequence gold went to a premium, soon being worth $1.15 per dollar. 
What naturally happened to it? 

4. Experts consider it very desirable that the bank note circulation 
should be elastic, — should expand readily when the need for money in- 
creases and contract promptly when the need diminishes. Of these two 
phases of elasticity, the second is in a sense the more important, in that 
it really provides for the first. In order to secure this power of prompt 
contraction, various provisions have been enacted or proposed: (a) Estab- 
lish a good many redemption agencies at convenient points throughout 
the country; (b) prohibit any bank from paying out in regular business 
the notes of another bank except in the city or district where the issuing 
bank is located; (c) prohibit the use of bank notes as reserves by banks 
outside the system; (d) take away the right of legal tender to govern- 
ment; and so on. 

Explain in each case why the provision set forth would naturally con- 
tribute to the contractility of the note circulation. 

5. In 1894, on account of excessive issue of silver and paper money, 
as also on account of the marked decline in business activity, the United 
States had a great excess of circulating medium. This fact (combined, 
doubtless, with other causes) led to a considerable contraction by ex- 
port to other countries. What kind of money must have gone? 

6. In 1886, Congress provided by law for the issue of silver cer- 
tificates of $1, $2, and $5 denominations, and in 1900 decreed that 90 
per cent of the total amount of such certificates should be in denomina- 
tions from $10 down. What did they hope to accomplish by this legisla- 
tion? 



CHAPTER XXXIV 

PRINCIPLES GOVERNING THE MOVEMENTS AND 
DISTRIBUTION OF MONEY 

The monetary stock of any country, as also of the world, is 
constantly in motion. Scarcely a day passes without the shifting of 
considerable sums of actual cash between different districts of the 
same country; and even the movements between nations, though by 
no means so frequent, are in the aggregate very extensive. 

Interest in Money Movements. — For various reasons these 
movements of money are of much interest and significance, both 
to the specialist and the general public. First, every money move- 
ment considered by itself tends to^ change the distribution of the 
money stock among different districts or countries; and, if for any 
reason the movement in one direction is long enough continued, 
it may cause an excessive supply at one point and a deficient supply 
at other points. As a matter of fact, this result is much less 
likely to occur than people commonly suppose, and even if it did 
occur it would probably be quite harmless. Occasionally, however, 
there may be changes of a really undesirable character; and so a 
knowledge of the principles governing them is needed as a basis 
for a corrective policy. Moreover, it will be decidedly worth our 
while to have a knowledge of even the harmless changes in distribu- 
tion, lest, in thinking them pernicious, we should suffer needless 
anxiety and make ill-advised efforts to modify them. In the second 
place, there are some kinds of money movements which indicate 
diseased conditions in the monetary system, and a knowledge of these 
movements is pretty certain to prove useful when we are trying 
to locate the trouble. We shall, therefore, in the present chapter, 
set forth the natural laws regulating movements of money between 
different countries or districts, and regulating the territorial dis- 
tribution of the stock of money which results from these movements. 

413 



414 PRINCIPLES OF ECONOMICS [XXXIV 

A notable fallacy in connection with the subject of money move- 
ments is almost constantly and everywhere current. It assumes 
that buying any goods or services from another country naturally 
means losing some of our stock of money to that country. If we 
give up the production of some commodity for which we show 
comparatively little fitness, and commence buying that commodity 
from our neighbors, people at once condemn the trade as certain 
to draw away a portion of our money. They may even fancy that, 
if we allow perfect freedom of trade, all our money will be drained 
away. 

Trade and Money Movements. — This error was fully, though 
indirectly exposed, under the Principle of Reciprocity, so a briefer 
statement, with a slightly different emphasis, will serve in the present 
connection. The dealings of one country with another, or, more 
exactly, of the people of one country with those of another, do 
not in themselves lead to net money movements. Even if interna- 
tional dealings were commonly effected with money directly, there 
would be few or no net movements, assuming that we have in mind 
intervals of at least a few months in length. The reason is plain. 
No sensible person wants money for the money's sake. Our neigh- 
bors are anxious to get money by selling their products, not because 
they wish to keep that money, but because they wish to use it again 
to buy our products. This fact appears clearly enough within the 
limits of our own town; and in no essential respect does the trade 
within a town differ from the trade between it and other towns, 
or from the trade between the country as a whole and other countries. 
Money naturally comes back as surely as it goes away. 

Again, under the credit regime which actually prevails in inter- 
local trade, no considerable movements of money ever take place 
except in very unusual circumstances. The reciprocal claims and 
obligations between the dealers of different countries which grow 
out of their trade dealings are transformed into claims and obliga- 
tions between the bankers or exchange dealers of those countries; 
and, between these bankers, money itself actually flows only when 
their reciprocal claims fail to balance. Furthermore, this failure to 
balance must be of appreciable duration — a few weeks at least; for 



XXXIV], MOVEMENTS AND DISTRIBUTION OF MONEY 415 

usually an exchange dealer with an adverse balance will as a first 
resort borrow from his correspondent, sending money only when it 
becomes evident that the adverse balance will not be turned into a 
favorable one for a long time. 

Capital Movements and Money Movements. — What we have 
thus shown to be true of trade relations, we can also show to be 
true of investment transactions — the lending of capital by the people 
of one place to the people of another place. Transfers of capital 
between communities, like trade payments, primarily take the form 
of debts between the bankers of the different communities. A 
person in England who lends money to an American railroad by 
purchasing its bonds does not send over money to that railroad ; his 
payment, exactly like a payment for wheat or cotton, appears as 
a debt created against some London house and in favor of some 
New York house. It is thus plain that, at the outset anyhow, 
such a shifting of capital does not constitute a movement of 
money. 

But, someone may object, would it not necessarily mean a move- 
ment in the end? For transactions in capital, unlike trade trans- 
actions, are almost certainly one-sided; Europe might lend much to 
America while America lent little to Europe, and hence, to balance 
the claims against them which have grown out of buying American 
bonds, the European houses would apparently sooner or later be 
compelled to send money. But even here another alternative is 
possible. While America holds an abundance of claims on Europe 
and may use them to demand money if she likes, she probably will 
not do so, because it is not money that she wants. The borrowing 
railroads do not want money, but rails, cars and locomotives. And 
either they will buy these articles abroad with the borrowed money, 
or they will buy abroad some other articles in order to release 
American capital and labor which can produce the rails, etc., at 
home; in either case, America buys from Europe more goods than 
usual. Thus the debt of European exchange houses to American 
exchange houses arising out of the fact that Europe is lending us 
capital, is likely to be matched with a debt of American houses to 
European houses arising out of the fact that Americans have bought 



4i6 PRINCIPLES OF ECONOMICS [XXXIV 

from Europe more goods than usual. The debts are accordingly 
cancelled and no money will flow either way. 

Circumstances Causing Money Movements. — We thus see 
that neither trade nor investment transactions necessarily involve 
money movements. They may, however, involve such movements, 
if the circumstances happen to be of a particular character. Con- 
fining our attention for the moment to trade relations, let us 
examine what those circumstances are. Any fact which causes the 
total volume of goods or services bought by any community from 
other communities to remain for some time in excess of its sales 
to those other communities, will tend to bring about a net move- 
ment of money from the community whose purchases are in excess; 
on the other hand, any fact making the sales of a community 
exceed its purchases, will tend to bring about a net movement of 
money into that community. The argument is too simple to need 
elaboration. The exchange dealers of a community which buys more 
than it sells will for a shorter or longer period be in debt to the 
exchange dealers of other communities. But the creditor dealers do 
not like to wait indefinitely for their pay, and so, if there is no 
promise of an early turning of the tide, they will probably order the 
money itself delivered. This principle is illustrated almost every 
year in the trade between America and Europe. The exports of 
America, being largely agricultural, are naturally "bunched" at cer- 
tain seasons; while its imports from Europe, being generally manu- 
factured products, are distributed more uniformly through the year. 
Consequently, temporary balances against Europe are almost sure to 
appear in the fall season and to lead to movements of money toward 
America. 

There are likewise conditions under which investment transac- 
tions may cause money movements. An exchange balance created 
against a lending country by the movement of capital is, as we have 
seen, usually offset through the natural readjustments of trade — 
the expansion of imports into the borrowing country. But if the 
movement of capital from country to country is very large and rapid, 
the growth of trade may not be rapid enough, for an extended 
period, to restore the balance. In this event, the creditor country. 



XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 417 

* 
unwilling to lose the use of its capital, if only for a few weeks, 
will probably order the gold shipped. 

Bringing the essential points of the foregoing discussion into 
a single statement, we have the following principle : 

Principle I. The dealings of one country {commun- 
ity) with other countries in respect to goods and capital 
do not in themselves naturally lead to net movements of 
money either to or from said country ; hut, if circumstances 
are such as to maintain a balance of claims for or against 
said country for a period of several weeks, a net movement 
of money to or from that country is probable. 

Based upon the above principle are five corollaries, each of which 
should, with only the briefest statement, explain itself. 

Corollary i. Money tends to flow to any country 
(community) where the rate of discount is exceptionally 
high, and vice versa. 

If the rate of discount in any country or community, let us say 
New York, rises to a point two or three per cent higher than in 
London or Paris, bankers having connections in New York will 
hasten to avail themselves of this opportunity to make exceptional 
profit by transferring funds to New York. Naturally, they will 
so far as possible use credit for this purpose. But, if the high rate 
persists and they continue to send funds, they will soon exhaust the 
available supply of credit and, thereafter, will send money. 

Corollary 2. Money tends to flow from a country 
where the stock is abnormally large as indicated by the state 
of the central reserves. 

This corollary is closely related to the last. An excessive money 
stock causes a fall in the rate of discount, which brings into opera- 
tion Corollary i. In extreme cases, an excess of money raises the 
prices of commodities; this naturally brings about an expansion of 
the import trade; and the latter, by creating a balance against the 
country, finally causes an outflow of money. 



4i8 PRINCIPLES OF ECONOMICS [XXXIV 

Corollary 3. There tends to he a continuous net flow 
of money from a country which is a producer of standard 
money metal. 

Corollary 3 remarks the tendency of money to flow from a 
country producing standard money metal. The reason for an out- 
flow of this kind is not far to seek. The natural and easy way to 
market standard money metal is to take it, directly or indirectly, 
to the mint, have it turned into money, and sell it as money — that 
is, spend it for goods. By this process the money stock of a gold- 
producing country is constantly being augmented, and is constantly 
becoming excessive; and with an excess of money there come into 
operation the influences already cited under Corollary 2. This 
proposition needs emphasis chiefly because it shows the folly of 
undue anxiety respecting an excess of gold exports from a nation 
producing a large amount of gold. We should expect, as a matter 
of course, that the custom house reports of the United States or 
Australia would show them exporting more gold than they import. 
Gold is one of their important products which they naturally use 
to buy things they cannot produce so easily, just as they use wheat 
or wool. 

Corollary 4. Money tends to How from any country 
which has experienced a marked decline in industrial ac- 
tivity. 

When business slackens there is less money work tO' be done ; this 
makes the existing money stock excessive, and so brings into opera- 
tion Corollary 2. 

Corollary 5. // a full weight metallic m^oney comes to 
command a premium, it tends to be exported from the coun- 
try. 

Full weight metallic money which comes to command a premium, 
is certain to be withdrawn from circulation almost completely ; since 
it will seldom be accepted in exchange at as high a premium as that 
given on the bullion market. But, being withdrawn from circulation, 



XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 419 

it becomes mere bullion, a metal, not money. Again, changing such 
a quantity of money into bullion inevitably makes the stock of bullion 
altogether excessive for the uses to which it can now be put. In 
consequence, the value of the bullion in the home market is lowered 
as compared with its value in other markets ; to put it a little differ- 
ently, the premium which the bullion bears at home is not so great 
as the difference between its nominal value as money and its value 
in other countries. It will therefore be exported to those countries 
where its value is greater. 

Money Drains Self-Corrective. — The discussion of Principle 
I and its corollaries must by this time have made it clear that pur- 
chase abroad does not necessarily mean a loss of money from the 
purchasing country. But, further, if we look more deeply into this 
subject, we shall find that money drains, when they do occur, can, 
in all but a few special circumstances, safely be left to correction by 
natural causes. 

Removes Its Own Cause. — First, the movement may be 
stopped by the automatic reversal of that condition which is neces- 
sary to bring it about. That condition is a high rate of exchange, 
a rate on London, for example, of $4.89; for obviously, the exchange 
dealer could not afford to send gold unless he got out of the transac- 
tion the value of a sovereign $4,866-!- plus the cost of sending it, 
about three and one-half cents. But such a high rate of exchange 
will naturally set up an unusually strong tendency for the export of 
goods. If I am selling wheat to London, when claims against Lon- 
don — which will be used tO' pay for my wheat — are selling at several 
cents above par, my trade will be unusually profitable, I will there- 
fore be eager to sell as much as possible ; but so will other American 
exporters be eager to sell, and, competing against each other, we will 
shade our prices ; with prices lowered, our eagerness to sell will be 
met with eagerness of Londoners to buy, — so' that our export of 
goods will increase at a bound. But what, now, will be the conse- 
quence of the increase in exports due to the high price of exchange? 
Manifestly, those exports will put Londoners in debt to us, will 
increase the supply of claims, or exchange, on London. But when 



420 PRINCIPLES OF ECONOMICS [XXXIV 

exchange becomes abundant, its price will inevitably be lowered. 
And, finally, since, as we saw at the outset, a high rate is necessary 
if gold is to be exported, the lowered rate will tend to check the ex- 
port. To put the whole argument in a sentence : Gold cannot go until 
exchange reaches a very high rate; but a high rate of exchange 
simulates exports ; the increase in exports presses down the rate of 
exchange ; and the lowered rate of exchange stops the outflow of gold. 

Starts into Operation Corrective Processes. — Not only is an 
outflow of money stopped by the automatic reversal of the condition 
which makes it possible, but, further, a persistent net movement of 
money tends to be stopped or even reversed by the action of condi- 
tions which its own continuance establishes. Three processes may 
be distinguished : 

First, a money drain from any country makes the surplus banking 
reserves from which money for export is taken, in the chief commer- 
cial centers (London, New York, etc.) relatively small. Depletion of 
the surplus reserve will raise the rate of discount — interest collected 
in advance — on short time loans ; since the rate on this kind of loan 
is almost entirely dependent on the size of the surplus reserve. A 
high rate of discount thus established will make the country a de- 
sirable market for lenders, and so will tend to draw in the floating 
capital of other countries. 

Ordinarily this process is adequate to stop an excessive drain of 
money; but, if it does not prove so, a new and slightly different 
series of reactions follow and usually effect the desired result. 
When the central banking reserve becomes scanty, the inclination of 
people to buy or hold international securities, — the trade in which 
is usually based on borrowed capital, — rapidly diminishes. With a 
fall in demand, the price of securities also inevitably falls. But a 
lower price for securities will encourage foreigners to buy them, thus 
giving New York an abundant supply of exchange on Europe. 
^Finally, since, as we have already seen, abundant exchange means a 
low rate of exchange, the condition necessary to further outflow — 
a high rate of exchange — is thus removed. 

There is yet a third chain of causation which comes into operation 
probably a little later than the others. The same high rate of dis- 



XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 421 

count which causes a fall in securities, if long enough continued, 
leads to a fall in the prices of the great export staples, such as cotton 
and wheat, which are speculated in like securities. This fall in price 
leads to increased buying by foreigners, which makes foreign ex- 
change abundant, thus lowering the rate of exchange, and checking 
the outflow of money. Finally, if the outflow went on long enough 
to produce a scarcity of money in the country as a whole, there 
would result a general fall in prices, which would stimulate foreign 
buying all along the line until the direction of the money movement 
was completely reversed. 

The foregoing arguments would seem to establish beyond ques- 
tion the following principle : 

Principle II. Every net movement of money tends to 
he stopped, or even reversed, hy the automatic reversal of 
that condition zvhich is necessary to bring it about, or by the 
action of conditions which its own continuance sets up. 

From the above principle it is only one step to the following 
corollary : 

Corollary. There is never any danger that an outflow 
of money from a particular country will go on till that coun- 
try is denuded of its monetary stock. 

Every net movement of money, even a moderate one, tends auto- 
matically to bring about its own stoppage. But, obviously, if this is 
true of every net movement, it would prove to be true of any move- 
ment so extensive that it threatened the complete exhaustion of the 
money stock. 

Automatic Distribution. — Another important principle regard- 
ing the distribution of the money stock, and one which is little more 
than a corollary from the last may be stated as follows : 

Principle III. Generally speaking, the monetary stock 
of a country, or group of countries having the same stand- 
ard, tends to distribute itself according to relative need. 



422 PRINCIPLES OF ECONOMICS [XXXIV 

If the need of any particular country, as compared with other 
countries, is less completely satisfied, this fact alone will tend to start 
a process of redistribution, which continues till the several needs are 
satisfied in equal measure. The explanation of this process has 
already been anticipated. If the stock of money in one country, as 
compared with another, is small relatively to the money work to be 
done, this fact will show itself in deficient bank reserves, and such 
a deficiency, causing the rate of discount to rise, will bring an inflow 
of money for investment. A high rate of discount will, moreover, 
cause the prices of securities and of the great staples to fall, again 
resulting in an inflow of money. The process by which an excess 
in any country is corrected by an outflow to other countries is simply 
the reverse of those described. There first results from the excess an 
expansion of the bank reserves ; large reserves bring down the rate 
of discount, making investments unprofitable; and this will cause 
capital — and, in time, money — to be exported. The low rate of dis- 
count will, moreover, occasion a rise in the prices of securities and 
the great staples ; foreigners will then begin to sell freely on our 
markets, thus expanding our foreign debt ; and a large foreign debt, 
raising the price of exchange, will very quickly result in the export 
of money. 

The above argument treats of movements occurring between 
highly developed commercial nations having the ordinary economic 
relations. As between small communities where standard money 
metal is produced, — for example, South Africa and the Klondike, 
on the one hand, and the rest of the world, on the other, the working 
of things is, if anything, more simple. The extraordinary abundance 
of money (for in such places gold, even in its raw form, at once 
becomes money) and the great scarcity of all other goods, make 
prices excessively high ; as a result, goods flow in at an extraordinary 
rate ; the community has constantly a large balance of indebtedness 
against it ; and money must constantly be sent out. 

Interference Sometimes Needed. — Up to this point our dis- 
cussion has placed a special emphasis upon the self-regulative char- 
acter of monetary distribution. If taken in too absolute a sense, 
this might lead to a misunderstanding. The last of our principles 



XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 423 

governing the movements and distribution of money must, there- 
fore, be one which in some degree qualifies those heretofore laid 
down. 



Principle IV. While, in general, the proper distribu- 
tion of the world's monetary stock among the different 
nations can safely be left to the working of automatic 
forces, circumstances may arise under which it is desirable 
consciously to control particular m^ovements of money, in 
order to maintain the stability of the system of credit. 

In a typical monetary system of our day, a large part of the total 
monetary stock consists of representative or credit money and bank 
credit. Under such an order, the foundation of standard money 
is vastly more important than any other constituent of the circulating 
medium ; it is not mere money ; it is emphatically the basis of the 
ivhole system. This is particularly true of that portion of the stock 
of standard money which we call the ultimate reserve, the reserve 
kept by a great central bank or, as in the United States, by the 
government, to redeem credit money. To maintain this reserve in 
adequate volume is of the greatest moment, not because we need it 
as a medium of exchange, but because, if it proves inadequate, the 
whole system will fall in ruins. 

Accordingly, it is natural that every extensive movement of 
standard money should be jealously watched with reference to its 
possible bearing on the ultimate reserve of the system. When that 
reserve is being drawn down, it is not enough to say that, in the 
long run, an excessive drain will correct itself. We cannot afford to 
wait for the long run, — serious consequences may overtake us in the 
meanwhile. The disappearance of the ultimate reserve would mean 
the overthrow of the standard ; and even the beginning of a depletion 
which threatened to be at all serious would excite such anxiety in 
the business world as gravely to injure industry and perhaps precipi- 
tate a panic. A nation may, for example, find itself experiencing 
the specie drain incident to a great war, a drain for which automatic 
regulation will not furnish a sufficiently strong or sufficiently rapid 
check. Or there may be a drain arising from the action of unwise 



424 PRINCIPLES OF ECONOMICS [XXXIV 

statutes or other artificial conditions, which at the very best cannot 
be changed for a long time. In such circumstances, it might easily 
be the duty of the government, or the great central bank, to take 
active and vigorous measures to check an outflow of standard 
money.^ 

Illustrative Problems 

1. During the years 1853 to 1864, inclusive, when France had a 
system of bimetallism at a coinage ratio of 15.5 to i, while the market 
ratio was about 15.3 to i, the French circulation absorbed about $680,- 
000,000 of gold, and ejected about $345,000,000 of silver. Explain these 
facts, using one of the corollaries of Principle I. 

2. "Between America and Europe there is usually a net movement of 
money toward Europe during the second quarter of the year, toward 
America near the end of the third, and early in the fourth, quarter." 
Explain why you would expect this to be true. 

3. "A country has never been despoiled of its money by the working 
of its international trade."— Gide's Political Economy, page 120. 

Why does he feel so sure about this ? 

4. A New York wheat broker sells 50,000 bushels of wheat to a 
Liverpool miller, and sells against it a sight bill of exchange for the 
proceeds, £8735 i6s. The wheat cost him 84 cents per bushel. 

(a) With exchange on London at $4.88, what would his profits be? 

(b) What would they be with exchange at $4.84? 

(c) What does this have to do with money movements? Explain 
carefully. 

5. "Between New York city, as the banking center of the United 
States, and the country at large, there is usually a great money movement 
outward from New York during the summer and early fall, and an in- 
ward movement toward New York during the late fall or early winter." 

Explain why you would expect this to be true. 



* The most important device employed for this purpose consists in raising 
the rate of discount, and thus bringing into operation Corollary i of 
Principle I. 



CHAPTER XXXV 

PRINCIPLES GOVERNING THE VALUE OF MONEY 

Thus far in our discussion of money we have treated it as a 
thing apart from the general field of economic goods, a thing pecu- 
liar, and governed by laws of its own. Again, in our chapters on 
Price (Chapters XXIX-XXXI), we for the most part spoke of econo- 
mic goods as if money, the thing in which the prices of those goods 
is expressed, were not to be considered as one of them, essentially 
the same in kind and governed by the same laws. But these impli- 
cations are misleading. Money is in a sense an economic good, just 
as wheat and cotton are economic goods, and the time has now come 
when we must so treat of it. We must show that money, the thing 
in which the values or prices of most other goods are expressed, is 
itself subject to the laws of value and price. 

The chief defect in our earlier reasoning lay in the assumption 
that money was constant in value. This assumption was encouraged 
by our emphasis on the idea that the money unit is tied to a certain 
definite quantity of substance, say 25.8 grains of gold, just as a gallon 
measure is tied to 8.33 pounds of water. But, as a closer examina- 
tion will disclose, any such view is decidedly inaccurate. 

The analogy between the case of the money standard and that of 
the liquid-measure standard is not as perfect as we have assumed. 
In using 8.33 pounds of water as a standard of liquid measure, we 
need have no anxiety that the bulk of the water itself will change, 
and so cause that of our unit to change; for we can nmke those con- 
ditions which would modify the hulk of water — temperature and 
atmospheric pressure — absolutely the same in all times and places. 

But we cannot parallel this operation with gold and its value. 
We cannot say that we will have as our money standard the value 
of 25.8 grains of gold under just the same conditions as prevailed 
when it was finally ado pied in 1873 ; for we can never reproduce 

425 



426 PRINCIPLES OF ECONOMICS [XXXV 

those conditions. All we can do, and all we try to do, is to keep the 
value of one dollar equal, at any particular time, to the value of 25.8 
grains of gold at thut same time. In doing this, we anchor the value 
of the dollar to a value which itself changes, and so, of course, the 
value of the dollar will change. Doubtless our policy in this matter 
is, on the whole, wise; for the vakie of gold changes very slowly, 
perhaps more slowly than that of any other single commodity, and, 
anyhow, we ought to have the same standard as the rest of the 
world, which is gold. But, whether wise or not, this policy anchors 
our money to something which changes in value, and so the value 
of our money changes, instead of remaining constant, as has all 
along been assumed. 

Measuring Money Value Changes. — But, although changes 
in gold and money value do occur, it is not so easy to establish 
the fact of change or to measure its extent as the student might 
imagine. Gold, being the standard of all great commercial nations, 
there is practically no market where its value is expressed in 
terms of anything but the money unit. There is, therefore, prac- 
tically no place where the apparent value of gold and money 
alters at all. In the United States, 25.8 grains of gold is always 
worth one dollar and, conversely, one dollar is always worth 
25.8 grains of gold. Hence, our only method of ascertaining changes 
in the value of gold and money is to study the movefnents of the 
prices of other things. If gold, and so money, should all at once 
greatly rise in value, their own price — in terms of each other — 
would remain constant, but that of goods and services in general 
would fall. Conversely, a sudden fall in the value of gold and 
money would show in a rise of the prices of all other things. It 
would seem, therefore, that we need only ascertain the changes in 
the general level of prices to know the changes in the value of 
money ; and, in large measure, this is what we try to do. 

Absolute and Relative Changes. — But we scarcely begin an 
application of this formula when we run upon difficulties of a most 
serious nature. Changes in the value of money would surely express 
themselves in opposite changes in the level of prices. But the level 



XXXV] THE VALUE OF MONEY 427 

of prices may also be affected by a sudden collapse of business de- 
mand or a great fall in cost of production. In other words, a 
change in the general price level may really be, not a change in the 
value of money, but a change in the value of goods. Or, to use a 
better expression, some changes in the general level of prices have 
their origin in causes affecting goods rather than money; and, if 
called changes in the value of money at all, these may be distin- 
guished as relative changes, while changes in the price level due to 
causes acting on money itself would be called absolute changes. 
A familiar instance of a relative change is the following: 
When, after a period of industrial stagnation, business begins to 
pick up, and people regain their faith in the future, there naturally 
takes place an expansion of demand for goods of all sorts, and in 
consequence a measurable rise in prices, starting among a few com- 
modities but gradually extending until it covers, if not the whole 
field, at least a large portion of it. As the boom advances, this 
movement becomes more and more pronounced. Every one, believ- 
ing prices will go higher, is eager to buy, that he may have something 
to sell at the higher prices; and, of course, his eagerness to buy 
means more demand and so contributes to the very price advance 
which he expects. This self-propagating movement continues until 
the expansion has passed all reasonable bounds, when suddenly some 
accident precipitates a general collapse of the boom, — pricks the 
speculative bubble. At once all are eager to sell, no one wanting to 
buy; and this sudden expansion of supply and contraction of demand 
causes a falling-off of prices, more rapid probably than the rise has 
been. These changes all take place, not because anything has hap- 
pened to money, but because something has happened to people or 
to goods. 

Take another illustration. If throughout a period of some length, 
say between 1850 and 1890, technical methods generally undergo a 
rapid improvement so that the costs of producing large numbers of 
commodities are much reduced, there naturally follows a decline 
in the prices of these commodities so great as to lower markedly the 
average, or general, price level. But such a lowering of the general 
price level could not properly be conceived as a real or absolute 
advance in money. In a very natural sense of the terms it is not a 



428 PRINCIPLES OF ECONOMICS [XXXV 

change in the value of money at all, but rather a change in the value 
of goods. 

So much for relative changes. In a study of money, however, 
it is of course not the relative changes, but the absolute changes 
which are really germane. Our reference to changes in the general 
price level have been made merely to guard against the danger of 
confusing them with genuine changes in the value of money. We 
turn now, therefore, to the real task of our present chapter, the 
analysis of these genuine, absolute changes. 

Quantity Theory. — The principle governing the value of 
money which is looked on by the majority of economists as most 
truly fundamental is known as the quantity theory or principle. 

Principle I. The value of money in any country tends 
to vary inversely as the quantity of money in that country. 

The Proof. — The argument for the quantity theory runs some- 
what as follows : If the quantity of money increases, people in 
general will have more to spend, will, therefore, demand more goods. 
But, if people demand more goods, nO' corresponding increase in such 
goods being provided for in the hypothesis, prices in general are 
certain to rise. Finally, such a rise in general prices is the same 
thing as a fall in the value of money. An analogous argument shows 
that a diminution in the quantity of money must tend tO' raise its 
value. Thus, if the quantity of money diminishes, people will have 
less money to spend, will, therefore, demand fewer goods, and so 
prices will fall ; that is, the value of money will rise. 

Confirmed in Experience, — This argument, though an a priori 
one, has at times been strikingly confirmed in experience. Thus, in 
a community which contains only a few thousand inhabitants there 
may occur a great gold discovery, producing, in a few months, bul- 
lion to the value of hundreds of thousands of dollars. As this bullion 
can be almost instantly turned into money or its equivalent bank 
credit, the money demand for all sorts of goods will at once greatly 
expand. In the output of goods, on the contrary, there will be no 



XXXV] THE VALUE OF MONEY 429 

corresponding increase. Consequently, the prices of goods in gen- 
eral show a rapid rise. And, since this rise is caused by the increase 
of money or its cheapening (in cost) or both, it constitutes a real or 
absolute fall in the value of money. In gold producing districts, 
such as California, Australia, and the Klondike, the new gold was 
generally used as money at once, in its bullion form, without waiting 
for coinage. The eager spending of this new metal to buy the 
necessaries and luxuries which the hitherto poor miners craved, 
naturally led to a swift advance of almost all prices, that is, a swift 
fall in gold. 

Application to Groups of Countries. — The application of the 
principle in a small community is thus easily shown ; but does it apply 
as well to an entire country, or to a whole group of countries? In 
such a country, or group of countries, will the value of money tend 
to vary inversely as the total quantity of money f The a priori argu- 
ment is, of course, still valid. An addition of 200 million dollars' 
worth of gold tO' the world's stock must surely tend tO' modify the 
gold, or money, demand for all goods other than gold, and so to 
modify the value of gold as measured in those goods. The new gold, 
or much of it, will be coined and pass into the monetary stock of 
the world; this will mean a corresponding enlargement of the ulti- 
mate reserves to which gold money is mainly relegated ; and this 
enlargement in turn will lead to an expansion of bank credit, and so 
of general purchasing power. As a result, buyers will find it easier 
to get possession of purchasing power. If they are already disposed, 
on other grounds, to go into the market as buyers of wheat, cotton, 
machinery, etc., the increased control of buying power will increase 
the demand for those goods. Finally, the increased demand will 
tend to raise the prices of those goods or, in other words, to lower 
the value of gold. 

Nevertheless, in a large country or in a group of countries the 
complete working out of this process cannot be looked for with any- 
thing like the same degree of confidence as in a limited district. 
That the value of money, even in such cases, tends to vary inversely 
as money quantity, assuming that sufiicient emphasis is laid upon 
"tends," would seem almost indisputable. The norm toward which 



430 PRINCIPLES OF ECONOMICS [XXXV 

the actual value of money gravitates, about which it varies under the 
influence of mor-e temporary causes, is in large measure determined 
under the principle noted. Nevertheless, this doctrine requires 
much qualification. Historical and statistical studies have seriously 
undermined it, and not a few economists have been tempted to reject 
it altogether. In the opinion of the writer, the doctrine contains a 
basis of truth which is of prime importance. But the limitations to 
which it is subject in actual experience and which seem at times to 
reduce its practical significance almost to nothing, must be clearly 
undcKstood. 

Limitations. — First, so far as gold, the standard money, is con- 
cerned, the quantity in existence changes relatively so little in a year, 
or even in a long series of years, that, however true the theory might 
be, we should have great difficulty in establishing a satisfactory proof 
of it. In the case of many commodities, as for example wheat, the 
output of a year constitutes almost the entire stock for that year, 
and a doubling of the output means almost a doubling of stock. But 
not so with gold. Its physical imperishability, its very high specific 
value, and its technical treatment as money make it, economically 
considered, immortal. It is almost never consumed in the sense of 
being irrevocably withdrawn from the market. The untold accumu- 
lations of the centuries are in large measure available to meet the 
needs of today. In consequence, an increase or decrease in the out- 
put does not cause anything like a corresponding increase or decrease 
in the stock. 

Another limitation, or set of limitations, upon the quantity theory 
grows out of the fact that in any modern monetary system, purchas- 
ing power, stated in terms of money, is not rigidly fixed by the quan- 
tity of money, but is almost indefinitely elastic. The whole point of 
the theory, as we have seen, lies in the assumption that if people 
have more money they will demand more goods, and that if they 
have less money they will demand less goods. It is easy, however, to 
show that many causes interfere with the prompt and eflfective 
working out of this process. 

First, a small quantity of money, frequently turned over, will 
demand as much goods as a large quantity of money circulating 



XXXV] THE VALUE OF MONEY 431 

slowly. Money demands goods every time it is spent or offered in 
exchange; and when it is not being offered in exchange it is not 
demanding goods. Hence, as the saying is, the nimble sixpence may 
do the work of the slow shilling. In a word, rapidity of circulation 
may neutralize any tendency to a rise in value caused by scarcity of 
money, and slowness of circulation may neutralize any tendency to a 
fall in value caused by an abundance of money. 

In the second place, under modern conditions the monetary 
stock has a degree of elasticity sufficiently high to neutralize, at 
least temporarily, changes in quantity. Only a small proportion 
of the actual circulating medium, the buying power in money form, 
consists of gold. A much greater part consists of bank notes, 
secured by small reserves of gold, and the issues of these may be 
expanded or contracted almost at will. 

But there is an even more important consideration. The general 
course of wholesale prices is largely determined in the great ex- 
changes where wheat, cotton, iron, petroleum, and so on are dealt in. 
Now, the exchange medium employed at these markets is not money 
in the narrow sense, but rather credit. Cotton, wheat, and iron are 
paid for with checks, and these checks practically never lead to a 
call for cash — the transactions are carried on almost entirely with 
deposit currency. But this sort of circulating medium expands or 
contracts virtually as it is needed, expands or contracts, indeed, with 
the expansion or contraction of the very business which employs 
it. Just because a dealer has bought 50,000 bushels of wheat, he can 
induce his banker to manufacture on his behalf say $30,000 in credit 
money, secured by that wheat, and ready to be used in buying more 
wheat. The new wheat, in turn, can be made the basis of additional 
bank credit, which again can be used in buying still more wheat. 

There must always exist, to be sure, a basis of real money ; every 
new bank loan must be secured by a certain reserve of standard coin 
or metal ; but the possible expansion of the loan is several times as 
great as the necessary addition to the reserve. Hence if business 
prospects look favorable both to the would-be borrower and the 
bank, the purchasing medium can be and will be expanded almost 
indefinitely, with only the slightest dependence on the stock of money 
existing at the time. On the other hand, if prospects are not favor- 



432 PRINCIPLES OF ECONOMICS [XXXV 

able, the buying medium, deposit currency, will not expand, no mat- 
ter how large the reserves of real money. Immediately it appears 
that the quantity of money has little to do with determining the 
demand for goods. 

Nevertheless, with all these qualifications, the quantity theory, 
as a statement of a general tendency, remains unshakable. In the 
long run, the general level of prices — the value of money — must be 
influenced by the quantity of money, particularly the quantity of 
standard money. 

Forces Acting through Quantity Principle. — If the value of 
money varies inversely as the quantity, we should need little argu- 
ment to establish certain facts concerning the effect upon value of 
various forces that influence the quantity. Since the output of money 
metal increases the stock, it must tend tO' diminish the value of 
money. Since a high cost of production tends to diminish output, 
and a low cost of production tO' increase output, then the one must 
tend to raise and the other to lower value — although, due to the 
highly speculative character of mining, this cause does not operate 
with anything like the promptness or certainty characteristic of 
many other industries. Finally, since the increase or decrease of 
money metal used in the arts must effect opposite changes in the 
amount of such metal available for use as money, they necessarily 
tend to increase or decrease the value of money. 

The facts just mentioned may all be briefly stated in a corollary of 
Principle I. 

Corollary. The value of money tends to vary inversely 
as the quantity of standard money available, and hence to 
vary inversely as the output of metal, directly as the cost, 
and directly as the quantity used in the arts. 

Conscious Adjustment Changes. — While the quantity prin- 
ciple is the basal doctrine for money value, special circumstances 
may arise in which one or two other principles have greater influence. 
Thus, the value of the substance used for the monetary standard may 
at times be determined quite independently of the quantity of money, 



XXXV] THE VALUE OF MONEY 433 

and then the value of money be fixed in accordance with the value 
of this ultimate standard substance. Whenever the value of the 
ultimate standard changes, as measured in at least one important 
commodity, then the value of the money dependent on that standard 
will also change. Business men of experience, alert and shrewd, 
will certainly refuse to sell goods at the old prices for money which, 
as measured in an altered ultimate standard, has fallen twenty or 
thirty per cent. And if they proceed to raise prices, this will consti- 
tute a change in the value of money by adjustment to a changed 
ultimate standard. 

Suppose the standard of a country is a metal which has the 
status of a mere commodity in some great world market where the 
country in question maintains intimate trade relations. Thus before 
1893, India had a silver standard. At that time, as now, silver was 
in London and other European centers a mere commodity, bought 
and sold like cotton or wheat. Naturally, it showed many fluctua- 
tions in price; and every marked fluctuation was followed by an 
opposite change in Indian prices, particularly of imported goods. 
When silver fell, Indian prices rose ; when silver rose, Indian prices 
fell, — in a word, the value of Indian money was readjusted to varia- 
tions in the world price of silver. This result was, of course, the 
natural one to expect. If silver fell, the value of Indian silver rupees, 
as measured in English pence, would fall ; it would take more of 
them to buy the goods imported from Europe; and so the dealer 
would have to recoup himself by charging more for the goods. But, 
if dealers in imported goods charged more, dealers in domestic goods 
would in the long run have to do the same, or else suffer a loss. 
Finally, if dealers in general charged more for their goods, laborers 
would presently have to begin charging more for their services. A 
rise in prices begun in the import trade would thus eventually be 
extended throughout all business relations. And this is merely to 
say that the value of the rupee was being adjusted to the value of 
silver. 

A second illustration : Suppose the standard money consists of 
irredeemable notes. Changes in the value of this money, as measured 
in the metal which was formerly standard, can be followed in the 
market price of that metal. Thus, during the American Civil War, 



434 PRINCIPLES OF ECONOMICS [XXXV 

gold went out of circulation and was speculated in on the open mar- 
ket just as cotton, wheat, and copper are now. Every day, every 
hour, its price, measured in greenbacks, the standard money which 
had displaced it, rose or fell. But this, of course, is the same as 
saying that the value of greenbacks, measured in gold, moved in the 
opposite direction, — fell or rose. Naturally, every seller of goods 
would note these changes in the greenback, since it was the measur- 
ing unit of the value of the goods he was selling. Naturally, too, he 
would sooner or later, make some effort to guard himself against loss 
from the fall in greenback values. Doubtless he would not try to 
readjust his prices to every change, but we can be quite sure that 
great declines, especially if long continued, would lead tO' a remark- 
ing of goods, a readjustment of prices to correspond to the decline in 
standard money. 

As a formal statement of the points here illustrated, we have the 
following : 

Principle II. Whenever the conditions are such that it 
is possible for the general public to have fairly conclusive 
evidence that a change in the value of the ultimate standard, 
as measured in at least one important commodity, has taken 
plctce, there will almost certainly follow, more or less rap- 
idly, a direct readjustment of the value of money {and so 
of general prices) to the changed ultimate standard. 

Credit Fluctuation Changes. — A third principle concerns the 
value of irredeemable paper money as affected by political or com- 
mercial uncertainty. Irredeemable paper money is merely credit 
money which has hitherto been redeemed freely on demand in the 
standard money, but on which, for the time being, redemption has 
been suspended. The type we have in mind is issued by the public 
treasury or a central bank closely allied to the treasury, for example, 
the Bank of England. When payment on such money has been 
suspended, it inevitably becomes the standard money as shown on 
page 398. Now, in normal times, when no public crises intervene, the 
value of money of this sort may remain at about the same point for 
months or even years. That point will be below the value of the 



XXXV] THE VALUE OF MONEY 435 

standard displaced, but not necessarily much below, depending on the 
quantity out, the skill with which it is managed, etc. But if any 
period is marked by uncertainty in public and commercial affairs, for 
example, if the nation is engaged in a war characterized by greatly 
fluctuating fortunes, anxiety will naturally spread abroad lest the 
government will in greater or less degree repudiate its obligations. 
This failure of the public confidence will of course react on the 
value of the notes as measured in the old standard, causing that 
value to show extraordinary fluctuations even within the limits of a 
single day.^ But this will not be the end of the matter. As brought 
out in discussing Principle II, dealers will more or less fully adjust 
their prices to the larger changes in the value of the irredeemable 
paper as measured in the old standard. The final result, then, will 
be that the value of such money, as measured in goods in general, will 
vary in a rough way with the degree of the public confidence in the 
certainty and proximity of its redemption. The following statement 
will formulate the conclusions of our argument. 

Principle III. During a period marked by much un- 
certainty, either political or commercial, the value of irre- 
deemable paper money is chiefly determined by public con- 
fidence in its ultimate redemption, varying directly as said 
public confidence. 

Miscellaneous Problems under Money 

1. "I can't understand what people mean when they say that money 
has risen in value since 1873. Money is by common consent the measure 
of the values of all other things; and so its own value must be fixed, — 
cannot rise or fall:" — A Gold Advocate in 1896. 

Explain his mistake. 

2. Why would changes in the total quantity of money in the United 
States between 1862 and 1879 naturally have had more influence on its 
value than equal changes would have had between 1850 and i860? 



* As seen in opposite changes in the value of the old standard metal, 
quoted in terms of the irredeemable note. 



436 PRINCIPLES OF ECONOMICS [XXXV 

3. Extract from a speech in the campaign of 1896: "If any man in 
this community would offer to buy all the eggs at 25 cents a dozen and 
was able to make good the offer, nobody would sell eggs for less, no 
matter what the cost of production, whether one cent or five cents a 
dozen. So with silver. Free coinage would establish the market price 
of silver at $1.29, and nobody would sell for a cent less." 

There is doubtless a sense in which the italicized claim is true but 
this is not the sense which was intended. The speaker meant that silver 
would rise to $1.29, as measured in the present dollar; so that there would 
be no repudiation of debts in adopting the free coinage of silver. 

(a) Show that such a claim is not established by this argument. 

(b) In what sense is the statement true? 

4. "We have altogether too little money in the country ($2,600,000) 
not enough to pay the railway debt ($6,000,000), or even the debts of 
banks to depositors, let alone the business debts." Explain fallacy. 

5. A few years ago Mexico had a silver standard. If at that time 
silver ha4 risen in value, would the Mexican dollar have risen in value? 
Would it have risen in price? Would the price of silver bullion have 
risen? 

6. In 1856 the monetary system of France was bimetallism at the 
ratio of 15.5 to i. The market ratio at that date was about 15.3 to i. 
What must have been the monetary standard? Prove. 

7. In the panic of 1893, when in America money was so scarce that 
business men and bankers had to resort to all sorts of substitutes, such 
as due bills. New York drafts, deposit certificates, etc., an eminent Amer- 
ican economist said in substance : "What do you think now ? Was I 
not right in contending that the stock of money is altogether insufficient ?" 

Did the facts establish his contention? 

8. Argument against Bryan in the campaign of 1896: "I can see 
how free coinage is going to increase the profits of the mine owners by 
doubling the value of silver; but I do not see how it is going to help the 
rest of us." 

Explain the fallacy in the words italicized. 

9. During the sixth decade of the XIX Century when France had 
bimetallism at a ratio of 15.5 to i, though the market ratio was about 
15.3 to I, dealers to their surprise every now and then received silver 
five-franc pieces in payment for goods. Why should this have surprised 
them? 



XXXV] THE VALUE OF MONEY 437 

10. "Unless the government redeems all worn coins at their face 
value, a coinage in active use always shows a strong tendency to de- 
terioration." 

Explain why this is bound to be true. 

11. "I object to our buying outside anything which we can produce 
at home; for this means just so much money lost from our coin circula- 
tion." 

Show that this is unsound 

12. About 1850, when the United States had bimetallism at a ratio 
of 16 to I, there took place a considerable fall in the silver price of gold, 
so that the silver in an American silver dollar was worth 2 to 3 cents 
more than the gold in a gold dollar. In consequence, silver coins gen- 
erally went out of circulation, only the much worn ones remaining. 

Explain (a) why most went out and (b) why some stayed. 

13. What is meant by saying that our mint ratio between gold and 
silver was i to 15.98? 

14. "New York, Dec. 11, 1903. The banks gained from the in- 
terior this week $2,042,906." — Newspaper. 

Was this normal ? 

15. "London, Oct. 3. One hundred and fifty thousand pounds sterl- 
ing gold will be shipped tomorrow to New York." Was this normal ? 



CHAPTER XXXVI 

THE PRESENT SYSTEM OF DISTRIBUTION 

The Problem of Distribution. — In our very first attempt to 
describe the nature of the existing economic order, we emphasized 
the point that that order is one in which men cooperate in the proc- 
esses through which they seek to satisfy their wants, — to make a Hv- 
ing. That cooperation is, indeed, spontaneous, its working out auto- 
matic ; nevertheless it is very real and covers by far the greater part 
of our economic activities. Economically, we constitute a vast or- 
ganic complex into which the individual more or less skilfully fits 
himself, and from which he more or less successfully makes his 
living. Since we thus constitute a vast organism, it is natural to 
conceive the product income of us all as a totality, a social income 
which is broken up into the individual incomes of the members of 
society. Thus conceiving the income of us all, it is natural to in- 
quire : What are the processes and principles under the operation of 
which the amounts of these individual incomes are determined? 
This, then, is the chief problem suggested by the term Distribution 
as the economist uses it ; and we must now devote ourselves to its 
solution. 

The above account of the nature of the problem which distribu- 
tion, as a division of economic science, presents to us should make 
it clear that that problem is not concerned with the division of the 
product of a given factory or mine or farm among the persons who 
participate in the operation of such factory or mine or farm. In- 
stead, our problem is concerned with the division of the total product 
of the zi'hole economic group in which is found that factory or mine 
or farm, — as well as many other factories and mines and farms, and 
also many other industrial concerns, — among all the members of the 
group. Our problem stated in the former way is not a legitimate one, 

438 



XXXVI] PRESENT SYSTEM OF DISTRIBUTION 439 

for it implies that we may reasonably think of the sharing of the 
product of a single industrial concern as being determined inde- 
pendently of other concerns belonging to the same general economic 
group, — a notion which is surely quite untenable. If we insist on 
using the word "shares" in this connection at all, we must mean by it, 
in the case of all participants but the entrepreneur, the sum or sums 
of money which are paid each one in exchange for his particular 
service. But this, obviously, is determined by multiplying the price 
of a unit of such service by the number of units rendered. That is, 
the fundamental determinant of the share of each is a price. But 
it surely is evident by this time that prices are things which are not 
fixed within the relations of a single concern, but over the industrial 
Held as a whole. What the chief engineer of a particular factory gets 
may be determined in almost entire independence of his contribution 
in that factory : from the standpoint of that factory, his wages may 
be aq^ absolutely fixed quantum which the concern has to accept from 
the general market, and in accord with which they have to adjust 
their conduct of the business. 



The Principal Kinds of Income 

Looking at the matter in a very general way, it may be noted that 
shares in the general social income may be either (i) economic or 
(2) non-economic. The former are such as are obtained through 
economic relations, processes, for example, wages from the sale of 
labor. Non-economic shares are any outside the above, for example, 
shares obtained by theft, cheating, governmental corruption, gift, and 
so on. Some incomes can with more or less reason be assigned to 
either class. Thus, many of the great incomes obtained in America 
from the exploitation of natural resources, such as lumber, copper, 
and oil, which we usually classify under one of the regular economic 
shares — ^profits — may also be conceived as in a sense non-economic, 
in that they often have their origin in the foolish or corrupt munifi- 
cence of government. Naturally, the study of incomes undertaken 
here will be concerned with those which can properly be called 
economic. 



440 PRINCIPLES OF ECONOMICS [XXXVI 

The chief economic incomes or economic shares in the social in- 
come are wages, interest, profits, and rent. These terms need little 
definition. Wages are a form of income which men receive in return 
for personal services — labor. Interest is the capitalist's remunera- 
tion for "carrying" the reserves of the community, supplying the 
service of waiting, and takes its purest form in loans where risks 
are practically eliminated. Profits, on the other hand, are the re- 
muneration paid especially for taking the risks or, better, for taking 
the responsibility of ownership . Rent is the hire paid for the use of 
unproducible or indestructible elements in land. 

Again, we should note as a general point that economic incomes 
are of two distinct classes — personal incomes and property incomes. 
Personal incomes, which men receive in exchange for personal 
services, may in practically all cases be brought under the category 
of wages, though in ordinary speech remuneration for the higher 
forms of personal service is usually called salary. Property- in- 
comes, those which men receive in exchange for services given by 
the property they own, fall into three classes, rent, interest, and 
profits. 

Functional Distribution. — The above account of w^hat we have 
called the economic shares suggests that distribution under the pres- 
ent order is primarily a functional process. Each member of society 
receives a share which is supposed to represent the effective social 
importance of the function which he performs directly or through 
some factor which society authorizes him to own. Such a system of 
distribution is not logically necessary. We could conceive an order 
in which shares were determined independently of function, for 
example, one in which all shares were equal, as is commonly advo- 
cated for communism. On such a plan, it would still be necessary to 
try to ascertain the effective social importance of each function, in 
order to have the information needed to enable us wisely to utilize 
our stock of the various primary factors. But that knowledge would 
not influence the community in distributing the social income. The 
present order, however, makes income correspond to function. This 
view of the matter explains how it is that the economist, when study- 
ing distribution, seems to busy himself almost entirely with what is 



XXXVI] PRESENT SYSTEM OF DISTRIBUTION 441 

often called "functional distribution," the allocation of the social 
income to the several different functions which had to be performed 
in order to produce that income. 

Personal Distribution. — In contrast to functional distribution 
as thus described, we have "personal distribution," meaning the allo- 
cation of shares to actual, concrete persons. Manifestly, these two 
distributions are not necessarily identical ; since any person may be 
in receipt of more than one functional share. Still the process of ex- 
plaining incomes compounded of two or more functional shares 
offers no difficulty, since such incomes are mere aggregates of the 
functional shares entering into them. Accordingly, the economist 
seldom feels called on to go much beyond mere functional distri- 
bution. 

Illustrative Problems 

I. Mr. Crane puts $3,000 into a grocery business and works him- 
self in the store from morning till night. His net return from the busi- 
ness is $1,500. 

Make an imaginary distribution of this income into the several eco- 
nomic shares which are probably involved. 

2. My friend has eight houses and lots in Ann Arbor which he rents, 
getting for each, let us say, $360 a year. Try to break up this sum into 
the different elements which probably enter into it. 

3. At a certain inland resort rowboats are let at $1.50 per day. 
Enumerate the different elements entering into this sum. 

4. "Production is, so to speak, a synthesis ; distribution, an analysis." 
Explain what seems to be meant. 

II 

General Character of the Process Determining the Regular 
Economic Shares 

Distribution an Exchange Process. — Generally speaking, the 
process whereby these regular economic incomes are determined is 
simply the price-determining process, which we have discussed at 
length. The correctness of this statement may be seen from a 
mere preliminary examination of the economic incomes which will 



442 



PRINCIPLES OF ECONOMICS [XXXVI 



show that the source of each is in reahty nothing more than the 
price of something. Thus wages of all sorts — whether those of a 
mechanic in the automobile factory, for example, or those of a sales- 
man, advertising writer, or general manager — are nothing .but the 
prices of labor services brought by the laborer to market. Interest 
also is plainly a price; for, as we have conceived it, the lender makes 
a sale of the service of waiting. Rent is the price paid for the use 
of land unmodified, or modified only by improvements which are 
indestructible. The case of profits, though on the surface less evi- 
dent, is at bottom not materially different. The entrepreneur sup- 
phes the service of responsibility-taking. From the very nature of 
this service, it cannot he sold directly; but it is virtually sold, in that 
the entrepreneur unites this service with the services which he buys 
from other agents in the productive process, and sells the total result- 
ant on the general market. Profits, therefore, are in effect a price 
received for a service supplied. 

Another less direct but not unimportant sense in which incomes 
are determined through exchange processes should perhaps be men- 
tioned in this place. The immediate income which most of us receive 
is of course an income of money or its equivalent. But to realize this 
income, to obtain gratification for our wants, we have to turn the 
money into commodities or services — bread to eat, clothes to wear, 
rides on the train, etc. Now, obviously, the amount of such goods 
which we enjoy must depend in large measure on the money prices 
of those goods. But this, in turn, is a matter of exchange. Hence 
the amount of goods we can enjoy — our real income — depends, again, 
on the processes of exchange. 

But we need not be content with saying that the sources of the 
economic incomes are the prices of services, economic goods, which 
the income-receiver sells, and that those incomes are determined, 
through exchange processes, by the laws of price. We can be more 
specific. We can affirm that the particular services in question, the 
services of labor, land, capital, and responsibility-taking, belong to 
the class of economic goods which were earlier designated primary 
factors or cost-goods. A primary factor, as we remember, is one 
behind which economic analysis cannot reach, which can be traced 
to no more ultimate source ; and we should be able to see with little 



XXXVI] PRESENT SYSTEM OF DISTRIBUTION 443 

effort that the factors under discussion answer completely to this 
description. 

The services of land are obviously primary factors, for they 
flow without man's assistance from a source which man has not 
made. Labor services again, for which wages are paid, flow from an 
unproducible source — labor power. For, although labor power is, 
literally speaking, produced and continually reproduced by the nat- 
ural propagation of the human species, it is seldom, except under a 
slave regime, brought into existence primarily for market purposes; 
it occurs only as an incident to living and precedes the origination 
of economic motives; and we may accordingly look upon labor as 
one of the ultimate things in our analysis, something behind which 
we cannot go. An equally clear case can be made out for waiting 
power and responsibility-taking. These factors are indeed supplied 
by men on their own free choice, and, unlike labor power, are sup- 
plied from preconceived motives of an economic sort ; but they are 
preceded by no factors of a strictly economic kind — in reaching them 
we have reached a point beyond which economic analysis cannot 
penetrate. 

We have seen that the services of labor, land, capital, and respon- 
sibility-taking are primary cost-goods. In consequence, wages, rent, 
interest, and profits, being the prices of these different services, are 
prices of primary cost-goods. Naturally, then, the particular law of 
price operative in determining these distributive shares is the one 
which determines the prices of primary cost-goods. But the principle 
governing the prices of such goods has already been brought out 
in Chapters XXIX and XXX. It follows that the principle there 
set forth is in essence the principle which in the long run governs 
the regular economic incomes, wages, rent, interest, and profits. 
Formulated as a principle governing distribution, it may be stated 
as follows: 

Principle. Every economic income tends to approxi- 
mate that quantity of goods which constitutes an expression 
of the marginal significance to people at large of the actual 
output — when competition is free, the natural output — of 
the type of service rendered by the receiver of said income, 



444 PRINCIPLES OF ECONOMICS [XXXVI 

and which also, in the case of free competition, constitutes 
an expression of the net marginal disutility involved in fur- 
nishing said type of service. 

Ill 
Explanatory Comments 

(i) The principle of distribution above laid down is manifestly 
a compound one, in that it asserts the coincidence of income both 
with the marginal significance of the service rendered, and the mar- 
ginal disutility of rendering it, provided there is such a disutility. 
The full title of the principle, therefore, would naturally be the "sig- 
nificance-disutility principle." It is possible, however, to treat the 
two parts as separate principles ; and this is perhaps desirable at 
times, because the first is accepted by some economists who would 
demur at the second. 

At any rate, the first part of the principle, which is much the 
more important and oftener the subject of reference, will certainly 
require a separate title of its own. We shall therefore frequently 
allude to the "significance principle," which affirms that the price 
of any primary factor tends to be such as will express its mar- 
ginal significance ; or, in other words, that any economic income tends 
to be such as will express the marginal significance to people at large 
of the service rendered by the primary factor in question. Another 
designation occasionally used is the "service value principle," the 
principle that each person tends to get an income which represents 
the value of his service or contribution. 

(2) Our principle affirms that every economic income tends to 
approximate (not equal) that quantity of goods which expresses the 
marginal significance attaching to the service rendered. If the mar- 
ginal significance of a piece of land, for example, is $500, the rent 
paid for that land will approximate $500, but not necessarily equal it. 
If the labor of carpenters has a marginal significance of $5.00 per 
day, the wages of this class of workmen will tend to be $5.00 per 
day, but not necessarily equal to that figure. The reason for this 
statement will be evident on a moment's consideration of the prin- 
ciples of price as already presented. 



XXXVI] PRESENT SYSTEM OF DISTRIBUTION 445 

We remember that there are four limits of price determination, 
the marginal demand price and the first extra-marginal supply price, 
above ; and the marginal supply price and the first extra-marginal 
demand price, below. Since it is perfectly possible that there should 
be a considerable interval between these limiting prices, actual price 
may vary over a considerable range. This statement manifestly 
applies to the primary factors from which incomes are derived, just 
as much as to other economic goods. 

(3) The principle teaches that each person tends to get an in- 
come which represents the marginal significance of his services. A 
given employer might be willing to pay $8 a day for carpenter 
service. But, taking employers all together, those who are least de- 
sirous of having carpenter work done find the service is worth to 
them only $5.00 a day. Five dollars, in other words, expresses the 
marginal significance of that type of service. The employer who is 
willing to pay $8 will therefore need to pay no more than $5.00 
per day. This is, of course, the same principle that applies in the 
purchase of bread, meat, coffee, and other ordinary commodities. 
Whether ethically right or wrong, there is nothing peculiar about it. 

(4) In the second part of our principle, it was said that every 
economic income tends to be one which constitutes an expression of 
the net marginal disutility of furnishing the type of service. The 
word "net" is introduced to provide for the following feature. The 
act of supplying certain services may involve advantages as well as 
disutilities ; university teaching, for example, gives men opportunity 
for the pursuit of scientific investigation, and practicing law gives 
men standing in the opinion of their fellows. Now, evidently, in 
cases of this sort, the reward received by the man who supplies the 
service does not need to be large enough to express the full disutility 
of his task, but only large enough to express that disutility minus the 
incidental advantages. An artist, scientist, or missionary, however 
great his labor, may find such pleasure in the exercise of his talents 
or in contemplating the result he hopes to achieve, that he will con- 
sider himself well paid if he receives only the b'arest living. 



446 PRINCIPLES OF ECONOMICS [XXXVI 

Illustrative Problems 

1. One eminent economist heads the chapters in which he treats Dis- 
tribution with the title Exchange-Distribution. Argue that such a head- 
ing is legitimate. 

2. "The economist commonly concerns himself too much with func- 
tional distribution, neglecting personal distribution." What is the point 
of this distinction? Argue that most that might be said under the head- 
ing of personal distribution is too evident to need much elaboration. 

3. "Orthodox economics teaches that the natural laws regulating 
distribution assign to each owner of a factor of production that portion 
of the product which is economically necessary to evoke and maintain 
the efficient operation of his factor, and nothing more." 

Assuming that the doctrine taught in this text is substantially that 
of orthodox economics, show that orthodox economics leaves room for the 
notion th^t the owner of a given factor in production might get some- 
thing more than the amount "necessary to evoke and maintain the effi- 
cient operation of his factor." 

4. "This contractor will lose $50,000 if his building is not completed 
September i. Bricklayers are worth $50 a day to him, yet he can get all 
he needs for $8 a day. How can you say that each of us tends to get 
an income which expresses the marginal significance of his service?" 
Point out the error. 



CHAPTER XXXVII 

THE GENERAL PRINCIPLE OF DISTRIBUTION: 
COROLLARIES 

Not Precisely Realized. — In affirming the existence of the 
general principle of distribution which was presented in the pre- 
ceding chapter, it was not intended to claim that that principle is 
precisely realized in the phenomena of actual life. The lack of such 
realization appears in both aspects of the principle but is especially 
notable on its significance side. Few contributors to production 
receive sums which exactly correspond to their contributions. Some 
get much more; a far larger number get less. But, in this respect, 
the significance principle is not materially dififerent from any other 
economic law. Those hypotheses which we assume as the starting 
point of all economic reasoning, absence of force, fraud, favoritism, 
monopoly, and other conditions interfering with freedom of competi- 
tion and contract — are far from being realized. Further, were none 
of these manifestly abnormal elements present, we should still have 
human ignorance, folly, and inertia, to hinder any precise realization 
of the principle. 

Sufficiently Realized to Be Important. — But, while this and 
all other principles of economic science are nowhere rigidly opera- 
tive, economic phenomena do, in a broad way, come under their con- 
trol. This statement is more conspicuously true of some other prin- 
ciples than of the one before us, but it applies to this one also. Such 
being the case, it follows that our significance principle should not 
and cannot with safety be ignored in affairs of the practical world. 
It frequently is ignored, as we know ; for not a few well-meant but 
ill-advised reforms run directly counter to it. But the outcome of 
such reforms, just because they neglect the principle, is invariably a 
partial and sometimes a complete failure. To bring out the connec- 

447 



448 PRINCIPLES OF ECONOMICS [XXXVII 

tion between such failures and our principle, we will set down a few 
of its more important applications in the shape of corollaries. Most 
of these concern the significance side of our principle ; but the last 
relates to its disutility aspect. 

~ Corollary i. Attempts to fix arbitrarily the amount of 
any economic share whether by governmental or private 
action without changing the demand for, or the supply of, 
the particular type of service involved can succeed only 
ivithin the narrowest limits. 

Illustrations of such attempts are found in the Statute of Labor- 
ers (1351) designed to keep wages at the old level in spite of the 
diminution of laborers through the black death and, more recently, 
in minimum wage laws and usury laws. 

All these measures, we should note, are attempts arbitrarily to 
regulate the value of something without changing demand or supply. 
It is at times possible arbitrarily to change prices, but only on condi- 
tion that one accepts the consequences in the shape of changed de- 
mand or supply. Thus, a monopolist may arbitrarily raise his price, 
but only on condition that he reconciles himself to smaller sales. So 
the workmen in a particular trade, if very strongly organized, may 
put up the wages of their trade, but at the same time they must be 
content with fewer jobs. So, again, if government insists on estab- 
lishing a maximum price for some producible service below the cost 
of supplying that service, it will have to be satisfied with seeing the 
supply of the service fall off. If in any particular case the action 
taken to fix prices does not alter demand and supply conditions, it 
can, as the corollary affirms, seldom succeed at all. 

The corollary, as stated, really contains two elements : ( i ) An 
admission that the shares can be, in some degree, fixed arbitrarily by 
legislation, and (2) a claim that this is possible only within very 
narrow limits. 

Let us begin with the first point. 

Scrnie Fixing of Shares Possible. — (i) A share can always be 
arbitrarily fixed within the limits set by the significance principle, as 



XXXVII] DISTRIBUTION: COROLLARIES 449 

against any departure to a point outside those limits caused by a 
failure of competition or the intervention of illegitimate elements. 
For example, rent is not seldom driven above marginal significance 
because of the ignorance or inertia of tenants; and government can 
then, without colliding with regular economic forces, bring it down 
to the proper level. (2) It is probable that there is nearly always 
some leeway between the marginal significance and the first extra- 
marginal one, in which case, our principle fixes, not the precise 
amount of each share, but only the limits within which it may range. 
But one point within these limits will reconcile supply and demand 
as well as another. Hence, within these limits, legislation can arbi- 
trarily fix on one particular point rather than another, without com- 
ing into collision with regular economic forces. For example, if 
wages anywhere from $1.20 to $1.40 would reconcile demand and 
supply, the law might fix them at $1.40, and not contravene our 
principle at all. (3) It is admitted that the prices of labor services 
or capital services or land services can be fixed at points somewhat 
outside the limits set by the significance principle because of the 
inertia or weakness of buyers or sellers of those services. But this 
being true, it is surely reasonable to claim that government, when 
public policy demands it, can take advantage of similar weaknesses 
consciously to fix prices somewhat outside the limits set by our 
principle. 

Limits of Such Fixing Narrow. — Such arbitrary fixing of the 
economic shares is possible only within very narrow limits. ( i) Law 
cannot long compel people to pay for anything more, — anyhow much 
more, — than it is worth to them. (2) Law cannot long hinder peo- 
ple from paying for anything as much, — anyhow almost as much, — 
as it is worth to the marginal buyer ; for this is the only way to insure 
that buyers at or within the margin will get the goods, as against 
buyers outside the margin, (3) Law cannot long compel people to 
furnish anything for a price much below that which expresses to 
them the disutility incurred in furnishing that thing. (4) Law can- 
not long hinder people from taking a price for their service sub- 
stantially as low as that one which expresses the disutility incurred 
in furnishing said service. 



450 PRINCIPLES OF ECONOMICS [XXXVII 

Corollary 2. Broadly speaking, the share per unit of 
each class of producing agencies varies inversely as the size 
of that class. 

Abundant land makes rent low ; abundant capital makes interest 
low ; abundant labor makes wages low. This obviously results from 
the joint action of our significance principle and the law of dimin- 
ishing marginal significance (page 305). Each productive agent 
tends to get an amount which expresses the significance of the con- 
tribution made by the marginal member of his class. But, since the 
larger his class the smaller will be the significance of the contribution 
made by the marginal member, therefore the larger his class the 
smaller the income which each member will get. 

In saying this, as in stating any other scientific principle, we of 
course assume continuity of conditions. An increase in the volume 
of any factor would not necessarily lower the rate of return if 
accompanied by the introduction of new opportunities for employ- 
ing that factor. 

Corollary 3. Broadly speaking, the share per unit of 
each class of producing agencies varies directly as the size . 
of other classes which cooperate with it. 

Increasing the size of one class of producing agencies increases 
the share of the others. For example, if capital increases in volume, 
not only does the rate of return to capital tend to fall, it is equally 
true that the rate of return to labor and land also tends to rise. 
The argument should be easy to follow. 

(i) According to the last corollary, the condition supposed 
lowers the rate of return to the changing factor. (2) Since the 
total going to said changing factor out of the product of earHer units 
of the combination is fixed by multiplying the number of units into 
the rate, said total will be smaller than before. (3) In consequence, 
the portion of the product of earHer units going to the other factors, 
being that product minus the total going to the changing factor, w'll 
be larger than before. Take a simple illustration : Ignoring capital, 
let us suppose that a certain piece of land will yield to one man's 
bbor 14 bushels of wheat; to the labor of two men, 20 bushels; to 



XXXVII] DISTRIBUTION: COROLLARIES 451 

that of three men, 24 bushels. When, now, laborers are so few that 
land needs to be worked in the first stage only, the whole product, 
14 bushels, will go to labor. When it becomes necessary to put on 
a second man, he will add only 6 bushels, therefore will get only 6 
bushels, and the first man also will get only 6 bushels, thus giving the 
landlord 20 minus 12 or 8 bushels rent. So when a third man has 
to go on, his significance and so his share will be represented by 4 
bushels; the shares of laborers i and 2 will fall to the same figure, 
and the total of the landlord will become 24 minus 12, or 12 bushels. 
Thus, increasing the number of laborers lowers their share and 
raises that of the landlord. 

That diminishing the size of one class diminishes the shares of 
the others, may be shown merely by reversing the preceding argu- 
ments. 

Corollary 4. Increase of population in itself tends to 
lower all shares hut rent, most of all common wages. 

This is really a sub-corollary from Corollaries 2 and 3. An in- 
crease in population means normally an increase in the size of all 
classes of producing agencies except land. Hence an increase in 
population would normally mean a diminution in the shares of all 
classes except those receiving rent. Further, this diminution would 
fall most heavily on wages for the reason that increase in population 
means a greater increase in labor power than in capital, that is, in the 
power to wait or assume the responsibilities of production. 

In opposition to the teaching of this last corollary it is sometimes 
argued that increase in population does not lower wages for the 
reason that each person brings into the world capacity to produce as 
well as capacity to consume. He adds, therefore, to the supply of 
goods just as much as to the demand. This merely shows that there 
is not ordinarily any danger that the new laborer will be unable to 
get any wages at all. It does not show that he will be able to get as 
high wages as before. Since the stock of natural factors in pro- 
duction and the stock of capital are not increased by the incoming 
of the new laborers, therefore the marginal significance of labor, 
and with it the wages of labor, must tend to be lowered. 



452 PRINCIPLES OF ECONOMICS [XXXVII 

Again, it is sometimes argued that increase in population, in that 
it makes a larger market and so justifies the resort to extreme 
specialization, large-scale production, etc., really raises marginal 
significance rather than lowering it, and so raises the shares going to 
labor and capital. This is doubtless possible but not, in my opinion, 
probable. In most countries population has long since reached the 
size which would justify a resort to the most efficient methods. If a 
particular community is failing to take advantage of the possibilities 
of large-scale production because markets are too small to justify a 
resort to that method, this smallness of the markets is probably not 
due to lack of the population necessary to make a large market, but 
to the lack of those facilities for transportation and communication 
in general which are necessary to coalesce the different small markets 
into one large one. 

Corollary 5. Any cause which restricts competition 
among the persons who supply a particular type of service 
tends to increase the rate of income received by the said 
persons. 

It is of course a fact familiar to the student that producers in all 
lines are disposed to adopt measures to limit competition, each in 
his particular line. Monopoly in some form or degree is a condition 
of things which, consciously or unconsciously, almost everyone tries 
to see realized in his special field. Perhaps the entrepreneurs in 
some industry, for example, sugar production, form a trust, thus 
establishing a combination so wide-reaching as to approximate mo- 
nopoly. Or perhaps the men engaged in building houses in a certain 
city form an agreement whereby they promise not to compete in the 
fullest sense against each other. Or perhaps the painters combine 
to restrict their numbers by refusing to take on more than a fixed 
number of apprentices at any one time. Now, it is doubtless hoped 
in each of these cases that the action described will increase the 
returns of the persons interested ; the entrepreneurs in sugar, and 
the building contractors will get larger profits, and the workmen in 
the case of painting will get larger wages. Further, it is doubtless 
true that the result thus hoped for is largely realized. Such re- 



XXXVIIJ DISTRIBUTION: COROLLARIES 453 

strictions of competition do usually increase the incomes of the 
persons interested. The reasons are plain. Diminished competition 
means decreased output, therefore higher marginal significance, 
therefore higher price, for the service rendered. 

The principle, as stated, says "rate of income" rather than simply 
"income" in order to provide for cases where restricting of output 
might increase the return per unit of service performed but not per 
person. Thus, the whole body of laborers might unite to keep, say, 
one-fifth of their number idle, hoping thereby to increase the total 
income of their class,^ while in fact they might thereby lower the 
total though increasing the rate — that is, the income per unit of 
service or effort. 

Corollary 6. Any cause which restricts competition 
among the persons who supply a particular sub-class of 
services tends to lower the incomes of the persons who sup- 
ply related sub-classes of services. 

As we have seen, it is very common to try to limit the output of 
one's own type of service in order thereby to raise the price of it. 
It is less common, but by no means rare, to hear persons who have 
inaugurated this policy attempting to enlist the sympathy and sup- 
port of others as if the public in general or producers in general, 
were to gain by it. That persons sometimes succeed in this attempt 
does not alter the facts of the ease. Their position is, generally 
speaking, quite untenable. We may sympathize with their aims, may 
even be glad to suffer some loss in helping them to realize those 
aims ; but we are bound to experience a loss — the policy in question is 
against the immediate economic interests of all but the persons di- 
rectly concerned. 

The explanation of this fact, in so far as it concerns related 
workers, should call for no elaboration. Restricting competition 
within any sub-class of productive agencies, say painting, drives the 
persons shut out of that sub-class into related sub-classes, — carpen- 
tering, masonry, etc., — thereby increasing the size of said sub-classes. 

* It probably can be shown that as a mere matter of economic theory 
this is a possible result. It does not, however, seem of sufficient importance 
to reward the effort. 



454 PRINCIPLES OF ECONOMICS [XXXVTI 

As a consequence, under the working of Corollary 2, the share per 
unit of those classes is lowered. 

Corollary 7. Broadly speaking, improvements in 
method through discovery and invention tend more espe- 
cially to increase interest and profits. 

Such improvements, by increasing opportunities for the employ- 
ment of waiting and risk-taking, increase the marginal significance 
of those factors, and so fulfil the conditions of the principle. This 
is not to say that improvements in method bring no advantage to 
laborers; but any advantage the laborer gets comes indirectly in 
lowered prices and in the greater quantity of goods which lower 
prices enable him to buy. 

As already noted, the disutility part of our principle is of much 
less importance than the significance part. Still it is not altogether 
negligible in practical affairs. In so far as any class of persons 
depend for their income on supplying some primary factor which 
involves a disutility, we cannot arbitrarily cut down that income 
without more or less interfering with the supply of that factor. 
This is the old story of killing the goose that lays the golden egg. 
One good reason for not interfering with the freely made price of a 
primary factor and the income derived from it is that only so can 
we be sure that the stock of said factor will be assigned to its 
proper tasks. But if the factor has a disutility cost, there is an- 
other reason for not interfering with its price and the income derived 
therefrom, namely, that, by pursuing such a policy, we are liable to 
cut down the stock or output of the factor. This point may be 
formally stated in the following corollary. 

•» Corollary 8. If the primary factor from ivhich an in- 

come is derived has a disutility cost, all artificial attempts 
to reduce that income are likely to reduce the supply of said 
primary factor. 



XXXVII] DISTRIBUTION: COROLLARIES 455 



Illustrative Problems 

1. Suppose that at a certain date, competition being free and general 
conditions normal, the rate of wages for ordinary labor is $1.50 per day; 
and suppose, further, that, under these conditions, the legislature passes 
a law forbidding anyone to pay or receive wages less than $5 per day. 
Do you believe that this would result in giving everyone wages of $5 
per day? Why? 

2. "The logic of their (the orthodox economists') teaching, has been 
that wages which were determined by free bargaining between capital 
and labor would be just or reasonable wages." 

Point out wherein the above is incorrect, or at least inadequate, as a 
statement of the real teaching of the economists. 

3. Quite soon after her entrance into the war. Great Britain under- 
took to raise a large revenue by the exceptionally heavy taxation of the 
industries especially connected with war, that is, the industries engaged 
in producing guns, ammunition, etc. What argument could be made 
against that policy? 



CHAPTER XXXVIII 

RENT 

In Chapter XXXVI we presented the general principle under 
which the four economic shares in distribution are determined. In 
this and the three chapters following, we give a somewhat more 
detailed study to each of the shares taken separately. We begin with 
rent. 

I 

The Nature of Rent 

As understood by the general public, the term rent commonly 
means the consideration paid for the use of any tangible object, such 
as a house, a horse, a boat, an automobile, or a piece of land. Eco- 
nomic usage is much narrower, for it includes, not hire in general, 
but only the hire of land. It does not include even the hire of build- 
ings, fences, or other removable or impermanent improvements 
standing on the land. When trying to be very precise, indeed, it 
speaks of rent as derived from the original, indestructible elements 
only of land, excluding all improvements wrought by man, even 
those of the most permanent sort. As a matter of fact, this usage is 
not perfectly feasible for the reason that some improvements are so' 
indestructible, so irremovable, so altogether permanent, that they 
become in effect inseparable parts of the natural thing itself. Thus 
a tile ditch laid in a field becomes once and for all a part of it; no 
one will ever take up the ditch, no one will need to give it more than 
an insignificant amount of repairs, and it will last indefinitely. Like- 
wise the increased fertility of the land resulting from its drainage 
is a quality which, though originally created as an improvement, can 
never again by any probability be extirpated, so long as the land 
itself endures. In consequence, the common practice is to interpret 

456 



XXXVIII] RENT 457 

economic rent as paid, not only for unimproved land, but also for 
land improved in the zvuys indicated. 

The difficulty which is usually met in the way just indicated, is 
by some writers met by refusing to distinguish the hire of land 
from that of other goods, — calling them all rents or hires. This 
practice has not become general, and, in my opinion, is of doubtful 
expediency. The chief reason is that, in connection with certain 
problems of value determination and particularly in connection with 
the incidence of taxes, strictly non-producible goods, fixed-supply 
goods, behave in a quite different way from ordinary producible 
goods, and improved land behaves generally like the strictly non- 
producible goods. 

II 

The Origin of Agricultural Rent 

Rent Originates Like Any Price. — Rent is a price — the price of 
the services given off by a piece of land during a given period of 
time. It follows that the most natural way to explain the origin of 
rent is that which is used in explaining other similar cases of price. 
Any appropriable thing will have a price, provided the demand for 
that thing at some price above zero is greater than the available sup- 
ply. Inadequacy of supply to equal the demand at any price above 
zero is sufficient to insure the existence of a price. Such inadequacy 
doubtless exists in the case of land services, anyhow in the case of 
services of lands which are superior in respect to fertility or loca- 
tion. This is sufficient to give such services a price and, therefore, 
sufficient to explain the existence of rent. 

Special Explanation: Surplus Theory. — But, while the 
existence of rent does not necessarily call for any explanation other 
than the one commonly given for the existence of price in other 
cases, it is customary, especially in the case of agricultural rent, to 
set forth some more specific and elaborate theory. Such theories 
are not to be conceived as inconsistent with the explanation of rent 
just given, but rather as explanations which go back a little further 
or in a little deeper, — explanations which attempt to show the process 
whereby the conditions indicated come to be fulfilled. The particular 



458 PRINCIPLES OF ECONOMICS [XXXVIII 

theory which most commends itself to the present writer may be 
called the surplus theory. 

First Hypothesis 

In explaining this theory, we will begin with the hypothesis that 
all the land is of one grade, and that its productive capacity is abso- 
lutely fixed — with just the right expenditure of labor, waiting, etc., 
it can produce a certain amount of product, less expenditure will pro- 
duce nothing, more expenditure will add nothing. Such a hypothesis 
is, of course, in the highest degree unreal, but it will serve best in 
bringing to light the causation process through which rent comes 
into existence. At the outset, then, we take the small isolated island 
of classical convention. That island, we will suppose, contains just 
1,000 acres of land of the same grade of fertility and the same de- 
gree of accessibility ; the sole agricultural product wanted is wheat,^ 
each acre of land will yield to the proper expenditure just 20 bushels 
of wheat, no more and no less ; and the cost of the labor, waiting, 
and other factors necessary to produce these 20 bushels — not in- 
cluding, however, the services of land — is $6 or 30 cents per bushel. 

Starting from this hypothesis, what condition or conditions will 
be necessary to bring rent into existence? In the first place, it is 
certain that this result cannot be reached, rent cannot exist, so long 
as the demand for wheat at every price higher than jo cents- — even 
one of only j/ cents — is less than 20,000 bushels. The best way to 
demonstrate this, perhaps, is to make the contrary supposition, that, 
through some process or other, rent did actually come to exist in 
spite of the fact that demand at 31 cents was less than 20,000 bushels ; 
and then to show that this rent would inevitably be eliminated 
through the spontaneous working of economic forces. 

Thus, let us suppose that, though the demand for wheat at 31 
cents is only 19,900 bushels, there has actually appeared on each acre 
in use a rent of 20 cents per acre, one cent for each bushel. Since, 
under this supposition, the farmer's outlay for each bushel amounts 
to just 31 cents, 30 for other costs and i for rent, the actual price 
must be at least at high as 31 cents, else production would not go on 



^Or wheat will be taken to represent agricultural products in general. 



XXXVIII] RENT 459 

at all. But an actual price of 31 cents means that the effective de- 
mand will be only 19,900 bushels. As a result, only 995 out of the 
1,000 acres of land will be wanted, since only that many are needed 
to raise the 19,900 bushels. But this fact will make 5 acres super- 
fluous; and the competition of these five acres for the 20 cents rent 
will reduce that rent to zero. Thus, the existence of rent is not 
possible so long as the demand for wheat at every price above costs 
other than rent is not as great as the total possible output.^ 

We have seen that, under our present hypothesis, rent could not 
exist so long as the demand for wheat at some price above 30 cents, 
say 31 cents, had not come to be as great as 20,000 bushels, the total 
capacity of the land. The complementary proposition, that rent 
would begin to exist as soon as this condition was fulfilled, provided 
that, in addition, the demand at 30 cents were greater than 20,000 
bushels — this proposition is easily established. As soon as demand 
had become equal to 20,000 bushels at 31 cents, while greater at 30 
cents, the buyers who were ready to pay 31 cents would have to bid 
the price up to- that figure in order to exclude the excess of demand, 
thus establishing a price of 31 cents. But, at this price, producers 
would get a surplus of i cent on each bushel or 20 cents on each 
acre; and, since prior to the increase in demand, the producers of 
wheat could afford to supply it at 30 cents, this surplus of 20 cents 
per acre would invite competition of producers from other indus- 
tries; some part of the 20-cent surplus would be offered to land- 
owners for the right to use the land ; and reciprocal bidding between 
possible tenants would go on till the whole surplus had been turned 
over to the landlord, or assured to him if he were his own tenant.^ 



^A theoretic complication is possible in which, though the demand at 
the above-cost price is not as great as the possible output, the demand at 
cost is greater than output. This case would be one of unstable equilibrium. 
Price must rise for a moment above cost in order to throw out a part of 
demand, and, in doing so, it would bring rent into existence. But this could 
be true only for the moment. The fact that demand fell below capacity 
as soon as price rose above cost would again bring down price and so 
annihilate rent. When this had happened, the excess of demand at cost 
might again send price up temporarily, creating rent temporarily, which 
would again be eliminated as before. And so this alternation might go on 
indefinitely. 

^The existence of rent does not require that a payment should be made 
from one person to another. The surplus over cost which goes to. or stays 
with, the landowner is itself the rent. 



460 PRINCIPLES OF ECONOMICS [XXXVIII 

Summary. — The above explanation of rent under our present 
very unreal hypothesis may advantageously be summarized before 
leaving it ; for it contains the essence of the explanation of rent un- 
der any set of conditions. The following will answer : When the 
demand for wheat at a price above cost has become as great as the 
capacity of the land, and demand at a price equal to cost has become 
greater than the capacity of the land, the actual price of wheat will 
rise above cost, this will create a surplus, and the competition of 
possible tenants will put this surplus into the hands of the land- 
owner, if tenant and landowner are separate persons, and fix it in 
the hands of the landowner, if these two are united in the same 
person. 

Putting the essence of the matter in still more compressed form, 
we may say that rent, at least under our present hypothesis, would 
come into existence when and because the possible outpiit of the land 
proved inadequate to satisfy demand except at some price higher than 
cost of production. 

Illustrative Problems 

1. .On the basis of the hypothesis just used, what would rent per acre 
be under each of the following demand schedules for wheat? (a) 18,000 
bushels at 36 cents; 19,000 bushels at 35 cents; 20,000 at 34 cents; 21,000 
at 33 cents; 22,000 at 32 cents; and so on? (b) 18,000 at 39 cents; 
19,000 at 38 cents; 20,000 at 37 cents; 21,000 at 36 cents; and so on? 

2. In the earlier days of economic study it was thought by some very 
able men that the existence of rent proves that agriculture is an especially 
productive kind of industry. When the true explanation of rent had 
been given, a famous economist declared that rent is due, not to the 
bountifulness, but to the niggardliness of nature. Defend that proposi- 
tion. 

Second Hypothesis 

We have seen how rent originates in the very simple, but very 
unreal, case furnished by our first hypothesis. Let us now change 
the hypothesis so as to bring it a step nearer to the facts of life. 
Let us suppose that the wheat land of our island is not all of one 
grade, there being only 100 acres of the grade which yields 20 bushels 



XXXVIII] RENT 461 

per acre at a cost of 30 cents, while the rest is distributed into 3 
parcels, one of 200 acres which will produce each 17 bushels at a 
cost per bushel of 35 cents ; another of 300 acres which will produce 
each 15 bushels at a cost per bushel of 40 cents ; and a third of 400 
acres which will produce each 13^ bushels at a cost per bushel of 
45 cents. In each case, greater expenditure would make no increase 
in output, while any smaller expenditure would produce no output 
at all. We will designate these different grades, 30-cent land, 35-cent 
land, 40-cent land, and 45-cent land, respectively. 

When, now, would rent appear under these new conditions? 
First, it is quite certain that there could be no rent so long as the 
demand for wheat at any price above cost on the 30-cent land has not 
become equal to the possible output of that land, 2,000 bushels. This 
proposition is plainly analogous to the first one laid down under 
the previous hypothesis, though this time the crucial figure in de- 
mand is 2,000 bushels, the possible output of the best land, instead of 
20,000, the possible output of all the land under the previous hy- 
pothesis. In substance, the argument for this proposition is the 
same as that used before. Any rent which might temporarily ap- 
pear under the conditions given would soon be reduced to zero by 
the spontaneous working of economic forces. The paying of that 
rent would necessitate an actual price for wheat of 31 cents; that 
price would reduce actual demand to less than the possible output 
of the 30-cent land ; this reduction in demand would throw out of 
cultivation some of said 30-cent land ; and the competition of the 
thrown-out acres would reduce rent to zero. 

Again, the conditions under which rent will appear and persist 
are substantially the same as before. Just as soon as the demand 
for wheat at some price higher than cost on the best land, say 31 
cents, had become equal to the total possible output on that land, 
2,000 bushels, while demand at the cost price, 30 cents, had become 
greater than 2,000 bushels, rent would begin to exist on the best land. 
For, under this condition, the price of wheat would necessarily be- 
come 31 cents; this would give a surplus over cost of i cent per 
bushel or 20 cents per acre; and the competition of possible tenants 
for this 20 cents would insure its being given to, or left with, the 
landowner. The explanation of rent is thus substantially the same 



462 PRINCIPLES OF ECONOMICS [XXXVIII 

as under our former hypothesis. That is, rent comes to exist when 
and because the possible output of the best land proves inadequate 
to satisfy the increasing demand except when actual price has risen 
to a point above cost of production on that best land. 

Inferior Lands Not Cause of Rent. — What, now, is to be said 
with respect to the relation of the inferior lands of our present 
hypothesis to the rent problem? If we have in mind the causation 
of rent, the most natural answer is that the inferior lands have no 
part in the matter. If they had been sunk under the ocean by an 
earthquake, if they had never existed, rent would have risen just 
the same and just as soon, that is, as soon as the capacity of the best 
land had proved inadequate to satisfy the increasing demand, save 
as that demand was reduced by the rising of actual price above the 
cost of production on the best land. But it is possible to interpret 
the affirmation that rent depends on the inferior lands, in a way 
that makes the proposition include an element of truth. These 
inferior lands are, after all, lands. If they were not inferior, we 
could count them right along with the best lands as adding so much 
to the total stock and so adding to the total possible output of wheat, 
with the result that the rising of the price of wheat, and so the ap- 
pearing of rent, would be much postponed. The reason why they 
cannot be so counted is that they are inferior. Their inferiority, 
then, counts indirectly as a limitation on the stock of best lands. 
This, however, seems like a very back-handed way of affirming the 
fact which really causes rent, namely : the fact that the supply of the 
best land is limited to 100 acres. 

Inferior Lands Check on Rent. — The above paragraph brings 
out the point that the inferior lands have no part in the origination 
of rent. Those lands do, however, play a very important role in 
rent determination, namely : limiting the amount of rent, checking 
its growth. Thus, if there had been no 35-cent land available, then, 
as soon as the demand for wheat had so increased as to become 
2,000 bushels at 36 cents, the price of wheat would necessarily have 
risen to that figure, and rent would have advanced to $1.20 per acre. 
Under the actual hypothesis, however, the result is quite different. 



XXXVIII] RENT 463 

When the price of wheat reaches 35 cents, it becomes profitable to 
work the 35-cent land ; as a result the possible output becomes 5,400 
bushels instead of just 2,000; hence the price of wheat cannot rise 
to 36 cents, though the demand for wheat at that figure has reached 
2,000 bushels, being kept instead at 35 cents as long as demand at 
36 cents is under 5,400; and so the surplus and rent are kept from 
rising. 

Illustrative Problems 

1. The existence of rent does not require that there should be differ- 
ences in the fertility or accessibility of the land. Defend that statement. 

2. Why would rent come sooner under the second hypothesis than 
under the first? 

Third Hypothesis 

Let us now bring our hypothesis into closer accord with reality 
by supposing that the productivity of the land is variable, not abso- 
lute, being governed by the principles brought out in Chapters 
IX, X, and XI. Accordingly, let us suppose that our best land 
does not show a cost for auxiliary factors as low as 30 cents till 
the land has been worked to the point of diminishing returns ; 
and that, after this point has been reached, a new expenditure of 32 
cents per bushel will add 10 bushels to the output per acre, and a 
further new expenditure of 34 cents per bushel will add 5 bushels. 
In short, after we have reached the point of diminishing returns 
in the working of the land, we shall have, on each acre of the best 
land, three legitimate productive opportunities: a 30-cent opportunity, 
a 32-cent one, and a 34-cent one; and we shall also have three 
possible outputs: 2,000 bushels, 3,000 bushels, and 3,500 bushels. 
Would this change in conditions require us to change our explana- 
tion of rent? In essentials, No. As before, rent would emerge 
when and because the demand for wheat at a price higher than cost 
on the best land had come to be as great as the possible output on 
that land. This time, however, a more explicit statement would be 
needed. Rent would emerge when and because the demand at a 
price higher than cost on the best land, that land being worked only 
to the point of diminishing returns, had come to equal the possible 



464 PRINCIPLES OF ECONOMICS [XXXVIII 

output of that best land -worked only to the point of diminishing 
returns. 

The reason for this change of statement is fairly obvious. Of the 
three opportunities present on the best land, the best, that is, the 
cheapest, will be first utihzed and will yield a surplus at a price 
which would be too low to justify utilizing the other opportunities 
at all. Thus an actual price for wheat of 31 cents would give, on 
each acre, a surplus, and sO' a rent, of 20 cents, though an actual 
price of ^2 cents would be necessary to induce farmers to utilize 
the 32-cent opportunity. 

The relation of the inferior opportunities for the production of 
wheat, derivable from the more intensive working of the best land, 
to the rent problem are the same as that of those inferior oppor- 
tunities which are derivable from the poorer grades of land. In 
causing rent, they have no part. Rent would arise at the same time 
and for the same reason, if they did not exist. On the other hand, 
they play an important part in checking the growth of rent. Under 
our previous hypothesis, rent experienced no check until it had risen 
to $1 an acre, that is, until the price of wheat had risen to 35 cents 
and so justified the working of the second grade land. Now, how- 
ever, there is a 32-cent opportunity on the best land, which oppor- 
tunity can be utilized as soon as actual price reaches 32 cents ; and, 
with its utilization, demand is temporarily satisfied, the rise of price 
is checked, and so the growth of rent is checked when it is only 40 
cents per acre. 

Fourth Hypothesis 

The last of our three hypotheses has brought us much nearer the 
facts of the real world ; but there is at least one very considerable 
point of difference left. Up to this time, the several costs of pro- 
ducing wheat which appear in the second and third hypotheses have 
been separated by considerable intervals. Under the second hy- 
pothesis, they differed by 5 cents, being 30, 35, 40, etc. Under the 
third, they differed less, but still by 2 cents most of the time, being 
30, 32, 34, 35, etc. Now, it can scarcely be doubted that in real life, 
even these smaller differences are too great. Very likely the differ- 
ent costs really grade into one another almost insensibly. Since, how- 



XXXVIII] RENT 465 

ever, producers would probably not be influenced in the amount 
they produced by changes less than one cent, let us suppose that, 
under the successively less favorable conditions of resort to poorer 
lands and more intensive cultivation, the costs of wheat are 30 cents, 
31 cents, 32 cents, 33 cents, etc., making a supply schedule for our 
island something like the one given in the accompanying table. Would 
this change in our hypothesis compel a change 
in our explanation of rent ? The true answer is 
surely a negative one. 



Price 


. Supply 


30 


2,000 


31 


2,500 


22 


3,000 


33 


3,500 


34 


4,000 


35 


4.500 


2(^ 


5,000 


27 


5,500 


and 


so on 



Real Cause Unchanged. — As before, the 
real cause of rent is the fact that demand at 
some price above the cost of production on the 
best land when cultivated to the point of dimin- 
ishing returns — the least cost before rent exists — is equal to the total 
possible output at that least cost, while demand at a price just equal 
to least cost is greater than the total possible output at that cost. 
The fulfilment of this condition causes actual price to rise above the 
least cost ; and thus is brought into existence a surplus on the best 
land, which is bound to go to the landowner. 

But, it may be said, under this new condition there will be a cost 
of production equal each time to the price which demand establishes ; 
may we not, therefore, say that price rises and so develops the rent 
surplus because the marginal cost has increased^ The answer is a 
negative one. When demand increases till it is 2,000 bushels at 31 
cents and 2,100 at 30 cents, the price rises to 31 cents, not because 
the latter becomes the marginal cost, but because no more wheat can 
be produced at the old cost of 30 cents. Were there no possibility 
of producing wheat at 31 cents, and, therefore, no chance that this 
could be the marginal cost, the actual price would just as certainly 
rise to 31 cents, and just as certainly cause rent to emerge. The 
correct statement of the case is this : actual price rises above the 
least cost and so rent emerges, because no more wheat can be sup- 
plied at the said least cost. But the appearance of the price which 
made rent also justified the raising of wheat at the next higher cost, 
which raising of wheat stopped the further rise of price and so the 
further rise of rent, thus bringing about a price for wheat, and so 



466 PRINCIPLES OF ECONOMICS [XXXVIII 

a rent, in tlte fixing of which the demand for wheat and the cost of 
production both participated. 

Ill 
Rent and Disutility 

In Chapter XXVIII it was maintained that the disutility cost 
involve'd in supplying the three factors of human origin, labor, 
capital, and responsibility-taking, had a part in determining their 
price. Can the same be said of the price of the services of land, 
that is, rent? The answer is of course a negative one. In order to 
have a real disutility cost, a factor must be of human origin ; hence 
land, which is not of human origin, can have no disutility cost. A 
particular piece of land may, like any other factor in production, 
have an opportunity cost. If it is needed for one purpose and we 
desire to put it to another purpose, the advantage of the former will 
have to be sacrificed, and this fact will probably have a part in 
determining the price. But this sacrifice is not a true disutility cost. 
It follows that rent is determined solely by the significance or utility 
of land or its services. This significance or utility is probably for 
one reason or another more easily ascertained for land than for any 
of the other factors; and so the significance or service-value prin- 
ciple is more fully realized for land than for labor, capital, or re- 
sponsibility-taking. But if land has no disutility cost, nO' disutility 
cost can influence its price. The disutility half of our principle has 
here no application. 

This matter, however, should not be left without further com- 
ment. While the furnishing of land services involves no original 
disutility, it does involve derivative disutilities. Under normal con- 
ditions, the market price of any piece of ground will approximately 
equal the capitahzation of its net income. In consequence, persons 
desiring to become rent-receivers will be obliged to invest their capi- 
tal in the land, just as if it were a producible commodity, — gaining 
the position of a rent-receiver will therefore mean assuming the 
ordinary capitalistic disutilities, abstinence, waiting, and risk-taking. 
Further, this process of capitalizing the income of land will almost 
certainly work itself out in such a way that the income pretty 



XXXVIII] RENT 467 

closely expresses the disutilities created. In consequence, it might 
seem that we ought to affirm that rent must be so determined as to 
be an expression of the derived disutilities of supplying the land 
services for which it is received. This, however, would not be true. 
The disutilities follow rather than precede the appearance of the 
rent. Hence they have no share in determining the rent. It is 
rather the price of the land which must he so adjusted as to make 
the rent an expression of the disutilities involved in furnishing land 
services. 



CHAPTER XXXIX 

INTEREST 

The subject of interest has probably given rise to more theoretic 
analysis than any other part of economics. This is due partly to 
the serious inherent difficulties of the subject, partly to the fact 
that such theoretic analysis, in the case of interest, connects itself 
with certain great practical controversies. Of these controversies, 
the most important concerns the ethical legitimacy of interest. From 
the earliest times there has been much opposition to this particular 
source of income as being essentially immoral. This opposition, seek- 
ing to strengthen itself theoretically by showing that there are no 
valid grounds on which the existence of such an income can be justi- 
fied, has devoted enormous energies tO' the study of the nature and 
origin of interest. Thus a purely practical problem has given im- 
mense stimulus to studies purely theoretical. It seems best, there- 
fore, that we should here enter into some phases of the subject quite 
fully; though what we have to say will not be unfamiliar, since it 
has been, in great part, anticipated in previous discussions. 



The Interest Phenomenon 

Explicit Interest. — Our first task must be to develop clear 
and definite ideas of what interest is. Its most familiar manifesta- 
tion is seen in connection with the ordinary money loan. A lender 
puts at the complete disposal of a borrower a sum of money; this 
money or an equivalent sum, is to be returned to the lender after 
a stated period; and, in return for the advantages which are sup- 
posed to accrue to him from this operation, the borrower makes to 
the lender a special payment amounting to a small per cent of the 
sum loaned and proportioned to the length of time for which the 

468 



XXXIX] INTEREST 469 

loan runs. This special payment is of course the interest we are 
talking about. 

Implicit Interest. — The type of interest just described is 
commonly called contractual, or, sometimes, explicit interest. It is 
open, avowed interest. But there are besides many business situa- 
tions in which interest, though just as truly present, is more or less 
concealed — implicit interest. Consider for example the relation 
between the prices of ordinary producible goods and their costs in 
other goods, current labor, and risk-taking. Each unit of product 
has a price high enough to cover not only the items just enumerated, 
but also interest on the invested capital,- — the sum of money which 
the entrepreneur could get from the sale of his whole outfit. This 
must be so, the business man would say, because otherwise no one 
would devote his money to manufacturing commodities ; instead, 
everyone would lend it, getting contractual or explicit interest. 

This is inadequate if it is meant to be a complete explanation of 
interest ; for sums of money are, so to speak, merely formal capital ; 
and the deeper explanation must be found in the interrelations of 
those things w^hich borrowed money is used to buy rather than in 
money relations as such. But it contains this much truth : It is in the 
market for money-loans that the various forces which are causing 
interest to exist and determining its rate, most completely manifest 
themselves. Accordingly, the business man's method of arguing at 
this point supplies a clue which will often tell us where to look for 
implicit interest. Wherever we find a person occupying an economic 
relation which deprives him of an opportunity to make money 
loans and receive explicit interest therefor, we may be sure he is in 
some way receiving implicit interest. 

Illustrative Problems 

1. How does the interest phenomenon manifest itself in the price of 
a dwelling house ? 

2. In the hire (rent) of such a house? 

3. In the price of a building site? 

4. In the fares charged by a steamship in the transatlantic service ? 



470 PRINCIPLES OF ECONOMICS [XXXIX 

II 

Essential Nature of the Interest Phenomenon 

The surface marks of the interest phenomenon have probably 
been shown with sufficient distinctness in the preceding discussion. 
When, however, we inquire as to the real inner nature of interest we 
find ourselves beset with more serious difficulties. Out of a rather 
confused mass of writing on this subject we may distinguish two 
principal theories : the use theory and the exchange theory.^ 

The Use Theory. — The use theory is almost universal in the 
business world and is still v^idely held by economists. According to 
this doctrine, interest is a payment for the use of capital ; capital be- 
ing conceived either as a sum of money or as money value embodied 
in some capital good. If a manufacturer borrows on his ninety-day 
note $600 to buy 200 tons of coal for his engines, he obviously gets 
all the uses of the coal but in addition he may be said to get a ninety- 
days' use of the $600 embodied in the coal. Similarly, if Mr. Elder 
buys a $1,200 automobile on a one-year note, he enjoys all the 
services which any cash buyer could realize from the machine and 
in addition he is thought of as having the use of $1,200 for a year's 
time. 

The Exchange Theory. — In explaining the exchange theory, 
our best procedure perhaps is to begin by pointing out the fault in 
the use doctrine. No one denies, of course, that the borrower or 
the credit buyer gets some advantage, service, or utility, in addition 
to the services of the coal or the automobile; if he did not, he 
surely would not pay the interest. But the use theory, many thinkers 
affirm, errs in its method of characterizing this advantage. The 
advantage of the man who buys goods with borrowed money or on 
credit consists, not in receiving a greater sum of utilities than the 



* It is not uncommon to conceive these as two different ways of explaining 
interest. I do not consider this view justified. The real explanation given 
by writers from each of the two groups is, in most cases, substantially the 
same. 



XXXIX] INTEREST 471 

men who buy similar goods with their own money or for cash, but in 
paying what is to him a smaller price. He enjoys all the preroga- 
tives of a man who has acquired ownership in goods by the process 
of purchase, although he has not made the complementary sacrifice 
naturally involved in a purchase, — has not in the deepest sense bought 
the goods at all. In short, his additional advantage over the non- 
credit buyer consists in postponing the sacrifice necessary to becom- 
ing the rightful owner of the utilities of the goods. 

The exchange theory as to- the nature of interest will now be 
readily comprehended. Interest, it affirms, is in reality a bonus, a 
premium, a something to boot which the man who buys goods now 
but does not himself pay for them till some future time, gives tO' the 
person who enables him to effect this transaction. Or, looking at 
the operations from the lender's side, interest is a bonus or premium 
which the man who relinquishes his right to goods now but gets his 
pay only at a later date, receives for making this exchange. To put 
the theory in more conventional form : Whenever present goods are 
exchanged for future goods, a bonus or premium is paid by the party 
who brings to the exchange future goods, to the party who brings 
present goods; and this bonus or premium constitutes interest. Ob- 
viously, this description best applies to contract interest, where one 
particular kind of goods, especially money, is borrowed with the 
understanding that just the same kind of goods is to be returned after 
a stated interval. But the advocates of this phraseology hold that it 
describes the real nature of every transaction wherein interest figures 
at all, even to the most obscure cases of implicit interest. The entre- 
preneur who buys raw materials, machinery, and labor, and com- 
bines these to produce shoes is in effect exchanging present for fu- 
ture goods; for the raw materials, machinery, and labor, though 
literally existing in the present, are not truly present goods, but only 
future goods, shoes in the making, shoes to be. 

Into the real merits of this controversy between the use and ex- 
change theories, it will scarcely pay us to enter. In general, we shall 
asume that the antithesis between the two is not as great as their 
respective advocates imagine. The man who exchanges present for 
future goods must, as a condition of doing so, be in a position to 
wait, — he must have a surplus of wealth which, measured in value. 



472 PRINCIPLES OF ECONOMICS [XXXIX 

equals the goods he exchanges for future goods. Speaking figura- 
tively, such a man must be the owner of waiting power, carrying 
power; and, this will usually be in the form of general wealth, — 
money or claims to receive money. To say that he sells the use of 
waiting power does not seem essentially different from saying that 
he exchanges present for future goods. 

Ill 

How Interest Comes to Exist 

Requisites of an Explanation. — In beginning the explanation 
of interest, it is natural to make a remark similar to that with which 
we introduced the explanation of rent. Interest exists because the 
demand (at some price above zero) for a certain thing is in excess of 
the output of that thing — in other words, because there is an extra- 
marginal demand for it. To explain the value of any object we 
have only to show that there are good reasons why there should be 
a demand for that object and good reasons why the supply should 
be limited. We are not called on to show that it must have value, but 
only to point out the conditions w^hich, if fulfilled, will insure its 
having value. In the case before us, the thing commanding a price 
is the service of carrying society's stock of reserve goods. In gen- 
eral, then, our task is to show (i) why there would naturally he a 
demand for carrying power, — or its equivalent loanable money 
funds, — and (2) zuhy the supply of this service would naturally he 
limited. 

Why Waiting Power is Demanded. — Among the reasons 
why there would naturally be a demand for waiting power are the 
following: (i) Overestimate of the importance of present Wants 
(spendthrift borrowing), (2) anticipated increase in income, and 
(3) the superiority of time-consuming methods in the production of 
goods or services. 

The first of these reasons needs little comment. Overestimation 
of present as compared with future wants, the conviction that one's 
immediately pressing desires are important above all things else and 
must be satisfied — this may be a foolish reason for borrowing, but 



XXXIX) INTEREST 473 

it is plainly a very real one. The second reason is almost equally 
familiar. Many people, particularly the young, think themselves 
justified in borrowing, even if only to have a little more pleasure in 
the passing hour, because they confidently anticipate larger incomes 
in the near future. 

The third, and much the strongest, reason why there is a demand 
for carrying power, waiting power, is to be found in the fact that 
the control of such power enables us to increase enormously our 
productive efficiency. The chief reasons why this is true were 
brought out in Chapter V, when we were illustrating the function 
of capital as a factor in production additional to labor and land. 
High productive efficiency requires that we should maintain a vast 
fund of reserve goods, goods devoted to the service of the future. 
The desire to attain this efficiency leads us to come on the market 
as buyers of the right to use the surplus wealth which constitutes 
capital. 

Why Quantity of Waiting Power* Is Limited. — I have dwelt 
on various reasons why there would naturally be a demand for wait- 
ing power, carrying power. It is equally easy to show that there 
would naturally be a limitation on the supply. As we already know, 
the ability to furnish this service of carrying depends on the ac- 
cumulation of a reserve fund of goods or money, and this accumu- 
lation can be made, in the last analysis, only through saving. But 
there are limits to the total saving capacity of a community. In the 
first place, the amount which a community could set aside for the 
future would of necessity always be limited by the total income; 
we could not conceivably save more than the total product of our 
efforts. But, again, we could not by any possibility devote even 
this total product to providing for the future, for some of our 
present wants can go unsatisfied only at«the cost of life. Further, 
it would be folly to sacrifice any present needs for the sake of future 
ones which were not of equal importance. Accordingly, a wise econ- 
omy would never build up the stock of carrying power for the satis- 
faction of future wants from that part of the current income which 
is needed to satisfy present wants of more, or even equal, impor- 
tance. 



474 PRINCIPLES OF ECONOMICS [XXXIX 

The share of current income which can be devoted to the service 
of the future is further hmited by the fact that future needs of a 
certain degree of intensity are not really as important as present 
needs of the same degree of intensity. For this there are two 
reasons, (i) Life itself is uncertain; the present we have, the 
future may for us never exist. A perfectly sensible and prudent 
person, therefore, will refuse to sacrifice a present want of a 
certain magnitude for a future one of the same magnitude. (2) 
Gratification of the present want is sometimes a condition necessarily 
precedent to the future want. Thus, the gratification of the present 
want may be essential to the continuance of life, or at least to the 
maintenance of that degree of physical and mental health which 
alone can fit us for the enjoyment of the future gratification. 

But, even if present and future wants of the same magnitude 
were equally important, we should still have a check on our pro- 
cesses of saving. This consists in the same tendency we have cited 
as a cause for the rise of demand for carrying power; namely, the 
almost universal overestimate of the importance of present wants, 
the almost universal underestimate of the importance of future 
wants. For the same reason that borrowers borrow, savers are dis- 
inclined to save anything to lend them. Not to gratify the want of 
today seems an unbearable hardship, while we contemplate without 
misgiving the deprivation of tomorrow. No doubt there are indi- 
viduals to whom these remarks do not apply; some people accumu- 
late much even with small incomes. But most of us spend freely 
or even carelessly ; and, as a result, the supply of the carrying power, 
the savings of the community for the future, accumulates less 
rapidly than it would if prudence in such matters were universal. 

We have thus shown why it is natural that there should be, on the 
one hand, a demand for carrying power, and, on the other hand, a 
limitation of the supply. This does not prove that there must be 
interest. To prove that, we should need to show that the conditions 
tending to build up a demand for carrying power and those tending 
to hmit the supply of carrying power are so potent that they neces- 
sarily make the demand at some rate of interest above zero greater 
than the supply at that rate. To prove anything of this kind would 
be from the nature of the case impossible. However, as was pointed 



XXXIX] INTEREST 475 

out in an earlier paragraph, we are not called on to undertake such 
a task. Our business here is to explain interest. This does not re- 
quire us to prove that interest must exist, but only to name the con- 
ditions which, if fulfilled, will cause it to exist — and this, plainly, 
we have done. 

Illustrative Problems 

1. "That capital is productive has often been questioned, but no one 
would deny that tools and other materials of production are useful; yet 
these two propositions mean exactly the same when correctly understood." 

Show that those persons who object to calling capital productive 
would hardly be satisfied with the above proof. 

2. Suppose that a fisherman could catch 21 fish a day without the 
aid of a net or boat or any other form of capital; that to make a net 
would cost him 30 days' labor ; and that it would last only 30 days. 

(a) What is the smallest number of fish which the net must enable 
him to catch each day in order to make it possible for us to credit any 
portion of the product to capital as capital? 

(b) Supposing that the fisherman catches with the aid of the net 
200 fish a day, what is the maximum productivity which could be 
credited to the capital as capital? 

(c) Under what circumstances would that maximum tend to be so 
credited to capital ? 

(d) Supposing that only 1,000 fish were actually credited to the net 
as its product, how would you explain the fact ? 

(e) Can you imagine a condition of things under which no part 
of the catch would be credited to the net? 

3. In order that we should impute productivity to capital, is it neces- 
sary that some part of the capital supplied have a cost of abstinence? 

IV 

Interest and the Significance-Disutility Principle 

Interest and Significance. — We argued in the preceding 
chapter that the economic share known as rent is with special ease 
brought into correspondence with the economic significance of the 
service rendered by land. We might almost as well have chosen 
interest as being peculiarly submissive to our principle. Almost ev- 
erywhere the capital market is especially free from interference, is 



476 PRINCIPLES OF ECONOMICS [XXXIX 

especially characterized by freedom of competition. If, then, the 
reasoning of Chapter XXX be accepted, — the reasoning that under 
complete freedom of competition the price of each primary factor 
inevitably tends to be one which expresses the marginal significance 
of that factor — we may be quite certain that this is true of interest, 
the price of the use of capital. 

There is, to be sure, probably no method of ascertaining directly 
and definitely the product-significance of a given unit of capital. 
Not a few writers believe such a method to exist, but I do not share 
their conviction. The economic significance of capital does not 
manifest itself in the same tangible way as does that of land. 

Nevertheless, the automatic process which we depended on in 
Chapter XXX to make the prices of primary factors express their 
marginal significance here operates freely and fully. On every side 
opportunities arise for the use of capital in order to substitute ma- 
chinery for labor. The advantage or disadvantage of such substitu- 
tion turns finally on the rate of interest, the price of the use of 
capital. Entrepreneurs compete or refuse to compete for the sup- 
plies of capital according as its price does, or does not permit a profit 
on its use. So, the owners of that capital openly compete against 
each other to insure its employment. If its price exceeds its mar- 
ginal significance, some portion of the supply will soon cease to be 
employed. If its price is below its marginal significance, marginal 
and intra-marginal users will have to bid it up to shut out the extra- 
marginal users. Entrepreneurs may be individually and collectively 
in complete ignorance as to the real marginal significance of capital ; 
but they have no difficulty ascertaining whether, at a given rate of 
interest, they can advantageously bid for more capital. Paying no 
attention to anything other than their own immediate profit, their 
spontaneous action finally brings the rate of interest to a point where 
it expresses the advantage of the marginal opportunity for the use 
of capital. 

Interest and Disutility. — Is the rate of return to capital gov- 
erned also by the disutility principle? Undoubtedly, as we have 
already argued more than once, the supplying of capital does necessi- 
tate some sacrifice or disutility. The question remains as to whether 



XXXIXl INTEREST 477 

the marginal portion of this sacrifice is expressed by the rate of 
interest. Doubtless a negative answer is possible. The volume of 
capital accumulation is influenced by other conditions than the rate 
of interest. For example, some persons are in a position to save 
from the present income without appreciable sacrifice while, at the 
same time, they desire to provide a surplus for the future. Such 
persons would accumulate capital even if they were obliged to pay 
for the privilege. It is, therefore, conceivable that the amount of 
capital actually supplied to the market is not influenced to any great 
extent by a regard to the interest paid. If not strictly a fixed-output 
good, it would have its fluctuations of output determined through 
forces other than cost. The price of its use, therefore, would not 
have to conform in any degree to the sacrifice of saving it. 

But, while this state of things is conceivable, it surely does not 
exist in fact. One type of accumulation, certainly, is motived by 
considerations of direct economic gain. I mean the getting to- 
gether of a small sum to make a start in business or speculation. 
Doubtless we are not here dealing with pure interest — the profit ex- 
pected is the more important item. Still the interest problem is also 
present, since the entrepreneur who puts his own capital into a busi- 
ness cannot help performing the waiting function as well as the 
responsibility-taking function. Now, every year a large amount of 
capital comes into existence in this way; and it is hard to believe 
that such capital has no influence in determining the rate of interest. 

But, finally, the accumulating of that portion of capital which is 
devoted to earning interest only must be materially influenced by 
the immediate reward in the shape of interest. Surely there are not 
a few people in such a position that they naturally say : The rate 
of interest has fallen so low that it really is not worth my while to 
save any more; I would better enjoy the present. If so, their de- 
cision for or against further saving must change the volume of 
capital sufficiently to modify its price. Putting the matter in a 
still different way, can we seriously doubt that a fall in the rate of 
interest to zero would diminish the stream of new capital, or that 
a rise to ten per cent would increase that stream? If not, then we 
must say that the price of the use of capital must tend to express 
the marginal disutility of supplying it. 



478 PRINCIPLES OF ECONOMICS [XXXIX 

V 
The Rate of Interest and the Quantity of Money 

In the Long Run. — Besides the general theoretic questions 
respecting interest already considered, there are one or two of a 
more practical sort which claim our attention. A very persistent 
and troublesome popular fallacy makes the rate of interest to vary 
inversely as the quantity of money; whereas of course the more 
ultimate causes determining interest are found, not in the demand 
and supply conditions of mere money, but in those of real capital, 
such as engines, machines, and lumber. This fallacy seems to spring 
from a popular confusion of money and capital. It is not unnatural 
in view of the fact that capital is always marketed in the immediate 
form of money or the money equivalent, bank credit. As a matter 
of fact, we may, in the long run, safely take as our guide to the 
interest relations prevailing among real capital goods, the market 
for mere money capital. But this is only because in the long run 
those interest relations prevailing among the real capital goods find 
full expression in the market for money capital. In the actual 
determination of interest the quantity of money plays little part. 

The argument is simple. What the borrower really wants is not 
money but goods, — engines, cars, rails, labor; and putting out more 
coin or more paper money will not make these goods cheaper to 
borrowers, nor will the withdrawal of money make them dearer. Or, 
if we suppose the rate of interest to be lowered at first by an in- 
crease of money, the natural working of things will soon reverse 
the movement, (i) The lower rate will lead to extensive borrowing 
and buying of goods. (2) This will raise the prices of goods; since 
they have not increased though the money has. (3) This will com- 
pel borrowers to borrow more money in order to get the same 
amount of goods. (4) This will raise the rate of interest again to^ 
its former place.^ Summarizing, we have the following principle: 



* In fact, it is generally held that, when the stock of money is increasing, 
the expected fall in its value — rise in prices — will cause lenders to hold back 
for a higher rate of interest in order to insure themselves against loss on 
the principal. 



XXXIX] INTEREST 479 

Principle. In the long run, the rate of interest must he 
determined in substantial independence of the quantity of 
money. 

For Short Periods. — But, while in the long run we cannot 
expect to influence materially the rate of interest by altering the 
quantity of money in circulation, we can for brief periods accom- 
plish this result. In fact governments and powerful banks at times 
consider it one of their functions to manipulate the money stock for 
the express purpose of raising or lowering the rate of discount. 
Thus the Bank of England has in several instances contracted the 
circulation of London in order to force on the market a higher rate. 
The possibility of bringing about such results in the way indicated 
rests upon the following facts. 

Short-time loans largely connect themselves with the need for 
money, not to invest productively, but to meet money obligations. 
The demand is thus emphatically for money itself, not something 
which money will buy. Hence the short-time rate adjusts itself to 
the marginal utility of money capital, without much regard to goods 
capital. Emphasis rests also on the fact that the short-time rate 
adjusts itself to the marginal utility of money capital with little re- 
gard to the disutility of saving. This is simply the old case of short- 
time normals being determined without respect to cost of production. 
During a series of years, the price of wheat tends to equal its 
marginal cost of production. But between two harvests its price 
tends to be one expressing the marginal utility of the existing stock. 

Principle. For short periods (a few -weeks or 
months), the rate of discount {interest) tends to equal that 
rate which expresses the marginal utility of the stock of 
money capital without mMch regard to the marginal utility 
of goods capital or the disutility of saving. 

VI 

The Rate of Interest and Risk 

At any one time the rate of interest on capital used for the same 
general purpose differs greatly, in different places, say Ann Arbor 



480 PRINCIPLES OF ECONOMICS [XXXIX 

and Spokane ; and even in the same place at the same time it per- 
haps differs widely when the capital is put to different u^es. The 
chief explanation of these differences is doubtless inequality in the 
matter of risk. The excess over, say, four per cent in a given time 
and place may be conceived as an insurance premium, necessary to 
cover losses from bad debtors, or perhaps as a payment necessary 
to overcome the natural indisposition of the lender to take chances. 
If we understand by "gross interest" the amount actually paid and 
by "pure interest" the rate to cover the simple use of capital, we 
may lay down the following principle, which though obvious and 
familiar, is unfortunately often overlooked. 

Principle. The amount by which gross interest in any 
particular case exceeds pure interest tends to vary roughly 
as the risk involved. 



CHAPTER XL 

WAGES 

As was the case with rent and interest, wages constitute the 
price of one of the primary factors. It follows that the general 
argument for the dominance of the significance-disutility principle 
over this share in distribution was implicit in Chapters XXVIII to 
XXX when we were showing that the prices of primary factors in 
general are determined by this principle. In the present connection, 
therefore, we need only to comment briefly on some facts which 
tend to modify more or less the workings of the general principle. 
We will comment first on matters which seem to interfere with the 
significance half of the price. 



Wages and Significance 

Labor Organizations. — One of the most important obstacles 
to the complete domination of the significance principle in the case 
of wages is the fact that there is more or less restraint put on 
competition by those who supply labor services : in a good many 
occupations, something like a labor monopoly exists. Restriction is 
secured both by limiting the number of laborers in a given field and 
by limiting through various devices the natural output of those per- 
sons who do get into the field. As a result, the share of these 
persons tends to exceed that which would express the marginal 
significance of the natural output of their type of service. In short, 
society has to pay for many of the higher services more than would 
be expected in view of the amount of those services which would 
naturally be forthcoming. Laborers who supply the services get 
more than they earn, using the latter term in its ordinary sense. 

We need not, however, take this concession too seriously. In 

481 



482 PRINCIPLES OF ECONOMICS [XL 

this age of publicity, free education, and universal initiative, few 
combinations could, in the long run, be successful in shutting out the 
competition of the really fit. Further, the policy of the trades unions 
is to some extent — though certainly not a large one — offset by an 
analogous procedure on the part of employers. Adam Smith, the 
so-called father of Political Economy, said that there always exists 
a universal, though tacit, combination among employers to keep 
wages down. This was probably nearer the truth in his day (1776) 
than now. The vastly greater extent of the market within which 
labor is bought and sold now makes tacit combination almost im- 
possible ; and formal combination for this end seems not to have 
been carried far. Still there is probably enough to offset in some 
measure the monopolistic combinations of labor. In short, it is 
probably safe to assume that the wages of even the higher forms 
of manual labor are not priced at a point materially above their 
natural marginal significance. 

Immobility of Labor. — Another obstacle to the complete 
domination of wages by the significance principle is the lack of mo- 
bility among laborers. We have all noted that the mere competition 
of sellers will not secure the advantage of buyers unless the latter 
are themselves reasonably alert. A shop may advertise ever so con- 
spicuously the fact that it sells the same wares at prices below those 
of its rivals ; but, unless buyers note the fact and act accordingly, 
they will not benefit from the favorable competition. But the con- 
verse proposition is also true. The mere competition of buyers will 
not insure good prices to sellers unless the latter are alert enough 
to become cognizant of the fact, and are in a position to profit by 
their knowledge. Ignorance, lack of means, inertia — by all of which 
laboring men are too frequently hampered — may combine to neutral- 
ize more or less completely the advantage which they might derive 
from the free competition of employers. 

Custom. — Another reason often given for expecting wages to 
be different from what they would need to be to express the mar- 
ginal significance of labor, is that wages in many fields are fixed by 
custom. Thus we have been wont for years to pay housemaids $3 



XL] WAGES 483 

to $4 per week in one social class, $5 to $6 in another, $7 to $10 in 
another. Similarly, the wages of common labor range usually from 
$1 to $1.50 per day. Now, without doubt, custom has some direct 
influence on the rate of wages; but that influence is, in the opinion 
of the writer, much exaggerated. In the first place, the facts do not 
display the degree of uniformity claimed. Within a few years a 
very marked change in the alleged customary standard has taken 
place. The amount which we commonly assume will have to be 
paid for one or another type of labor has changed three or four 
times in the memory of living men. Again, the uniformity claimed 
is not exact enough to show the effect of custom. Custom is nothing 
if not fairly inelastic. A custom which permitted men to wear at a 
formal dinner anything from a frock coat to a doctor's gown would 
not be called a custom at all. So, a custom which makes wages for 
one type of service range from $3 to $4 a week can hardly be called 
a custom. 

Again, if wages were so much under the influence of custom, 
we should see but little change in their rate due to inflation of the 
currency, rise in the value of the standard, immigration, booms in 
business, and other modifying conditions. But statistical investiga- 
tions have shown that wages, though moving somewhat slowly, do 
actually move in response to changed conditions. Finally, the con- 
siderations noted a few paragraphs back, publicity, general educa- 
tion and universal initiative, create a strong presumption against 
the belief that in our day mere custom can exert a marked influence 
in wage-determination. 

Bargaining. — We have, finally, to remark a tendency rather 
pronounced with some present-day writers to put forward the in- 
fluence of bargaining in the determining of wages as a reason why 
wages cannot, and do not, express marginal significance. These 
writers usually set out with the idea that the sole downward limit 
of wages is what the laborer will take, much as the upper limit is 
what the employer can afford to pay. They thus overlook altogether 
the part played by employers in fixing another possible lower limit 
to wages, and hence insure that the supposed lower limit shall be a 
very low one indeed, one leaving ample room for bargaining. But 



484 PRINCIPLES OF ECONOMICS [XL 

this analysis is certainly unsound. There is another lower limit ^ 
besides what the laborer will take, namely, the significance of labor 
to the first extra-marginal employer; and this limit is often much 
higher than the employee's minimum, so that the range of bargaining 
is much narrowed. Further, a good deal could be said for the con- 
tention that the laborer's minimum which really appears most of the 
time is the wage he believes he can get elsewhere ; it is not a true 
laborer's minimum but rather a minimum set by the extra-marginal 
employer. 

Generally speaking, then, bargaining does not seem to act upon 
wages with the force recently attributed to it, and does not seem to 
limit in any marked degree the dominance of the principle of mar- 
ginal significance. In so far as our principle is displaced by bargain- 
ing, this is probably true, not because bargaining as such can override 
the natural limits set by the marginal and first extra-marginal signifi- 
cances, but because the bargaining is, on one side, 'collective, monopo- 
listic. The individual employer has to deal, not with each workman, 
nor even with his workmen as a unit, but with the trade; and the 
trade as a totality has restricted competition in one way and another 
so that bargaining can move wages outside the limits set by the 
marginal and extra-marginal significances of the natural output. 
But this was already provided for in admitting that monopolistic 
labor could set limits other than those which would be established by 
the marginal significance of the natural output, 

II 

Wages and Disutility 

Overtime Labor. — An interesting confirmation of the con- 
tention that wages have to be such as to express the marginal dis- 
utility of supplying labor services, is to be found in the fact that 
everywhere laborers insist on higher rates of compensation for 
overtime work. The disutility attaching to an eleventh or twelfth 
hour of labor is greater than that attaching to the earlier hours, and 

'Oddly enough, the analysis is usually inconsistent at this point; for it 
does not ignore the part played by employees in fixing an upper limit which 
may be under that fixed by employers. 



XL] WAGES 485 

employers commonly find it necessary to offer higher rates for 
these extra hours to induce the desired supply of labor. 

Freedom of Action Lacking. — It is sometimes objected, in 

this connection, however, that the laborer's freedom of action is too 
limited, under modern conditions, to make possible the easy opera- 
tion of the disutility half of our principle. Under a simpler order 
of things the laborer might cease working as soon as the added 
utility, in the form of wages or goods, fell below the marginal dis- 
utility of his labor. He would stop his day's work at the end of 
say ten hours, or nine, or eight, unless an additional hour would 
clearly add enough to his returns to offset his discomfort. But un- 
der modern conditions the length of the day is largely a fixity, de- 
termined by custom and by the necessities of business processes. 
The latter commonly require the coordinated working of great 
numbers of persons and large volumes of capital. The individual 
laborer cannot decide of his own motion to shorten his day to 
nine hours or eight hours, for he is only a small part of a vast and 
complicated mechanism. This shortening of the day can only be 
done concertedly by the common consent of many employees and 
employers. 

Still Much Freedom. — This objection is not without; point, 
yet it has much less weight than one might suppose at first sight. 
The disutility of labor can act upon the supply and so upon the price 
of labor, not only by altering the length of the working day, but 
also by diminishing the total number of working days and the 
total number of men who work at all. The decrease in the number 
of working days, as a result of disutility, is especially conspicuous 
in times when the demand for labor is very great and wages conse- 
quently very high ; but at all times it probably plays a greater part 
than is commonly supposed. A very considerable per cent of the 
men who are engaged in the ordinary trades which we have in mind 
when speaking of labor in general, work a few days, weeks, or 
months, and then loaf for a time, not hesitating even to give up the 
present job, confident in the knowledge that they can easily find 
another. 



486 PRINCIPLES OF ECONOMICS [XL 

Only Freedom at the Margin Needed. — Doubtless the num- 
ber of men who are ready tO' quit work altogether and thus reduce 
the supply of labor, when wages are inadequate to cover the dis- 
utility as rated by them, is smaller than the number who quit work 
temporarily. Men are more loath to become dependent upon rela- 
tives, or "take to the road." But this number is not, after all, neg- 
ligible. It helps to give the labor supply an elasticity sufficient to 
make disutility a real factor in the determination of wages. For 
we must remember that it is not necessary that all or a very large 
part of the supply should be ready to drop out — it is sufficient that 
an appreciable margin should be in this attitude. 

Wages and the Standard of Living. — The effect of disutility 
on the supply of labor, and hence on wages, is brought about not 
merely by a decrease in the supply of labor services from men and 
women already living, but it is reflected also in the size of laboring 
men's families, and, so, in the future supply of labor. While there 
is probably little direct regulation of the size of workingmen's fam- 
ilies because of economic motives, yet, through both conscious and 
unconscious processes, population tends so to adjust itself that the 
typical rate of wages is compelled to coincide roughly with the work- 
ingman's conception of what is essential to a decent living. This, 
of course, means merely that the result named is effected in the long 
run. Laborers cannot raise their wages here and now merely by 
deciding that more is needed to insure a decent Hving. At any mo- 
ment their numbers are fixed ; and comparatively few will take to 
the road for the difference between $1.50 and $1.40 a day. Their 
wages, therefore, must for the moment roughly correspond to the 
marginal significance of their labor. But a given standard of living 
insisted upon through a series of years will express itself in dimin- 
ished population ; this, in the end, will raise the marginal significance 
of labor ; which, finally, will raise wages to the required height. 

A very practical application of the above principle is seen in 
the fact that the rate of wages can be altered by changing the ideals 
of the wage-earners. Adverse conditions may permanently lower 
actual wages, because those adverse conditions may hold wages be- 
low the old standard of living until the working classes have in- 



XL] WAGES 487 

sensibly come to accept a new inferior standard. On the other 
hand, favorable circumstances may work the opposite result. In 
short, a new level of wages brought about, and for some time main- 
tained, by temporary causes, tends to persist. 

The points brought out above may be formulated in the follow- 
ing principle and corollary. 

Principle. Under the natural working of economic and 
social forces, the long-run rate of wages tends to be that 
rate which will enable the working classes to maintain 
that standard of living which, in the particular time and 
place, is looked on as necessary to a decent living. 

Corollary. In the long run the rate of wages can be 
altered by changing the ideals of the working classes as to 
what is essential to a decent living. 

Illustrative Problems 

1. What bearing does our principle have on the question whether 
Chinese immigration should, or should not, be discouraged? 

2. "No remedies for low wages have the smallest chance of being 
efficacious, which do not operate on and through the minds and habits of 
the people." — Mill. 

Argue for the truth of this statement. (It probably needs qualifica- 
tion; but leave that for some other occasion.) 

3. Argue that, though the restrictive policy in the trades unions 
temporarily injures lower classes of workingmen, in the long run it is 
likely to raise wages generally. 

Ill 

The Theory of Employment 

Employment and Say's Law. — One aspect of the wages 
problem which has the greatest practical importance for every 
worker is employment. Some of the most important aspects of 
this matter connect themselves with a topic discussed much earlier 
in this text under the title of Say's Law. In our present connection, 



488 PRINCIPLES OF ECONOMICS [XL 

we will merely enumerate some of the corollaries of that law apply- 
ing to employment. 

( 1 ) The destruction of objects of wealth which are hound to he 
replaced does not increase employment. 

(2) Private expenditure for extravagances, as contrasted with 
other forms of expenditure or even with hoarding, does not increase 
employment. 

(3) Governmental extravagance does not increase employment. 

(4) Producing for oneself, when it is done without decreasing 
one's output for the market, does not diminish employment. 

It might be well, perhaps, to give this last proposition the benefit 
of an illustration. A person who produces through his property 
or his efforts, say, $1,000 worth of products each year, does not 
diminish employment by putting in some spare time building 
himself a rowboat. Assuming that his outside production is not 
changed, his demand for goods on the market is the same as 
before, and therefore creates the same volume of employment 
opportunities. 

(5) Broadly speaking, an increase in the supply of lahor services 
creates opportunities for employment as well as absorbing them,, 
though not usually in quite the same proportion. 

This proposition is not so evident as the preceding; nor can it be 
accepted without larger qualifications. But it is still substantially 
true. If the whole producing group creates a demand for labor by 
producing, it follows that the labor part of the producing group cre- 
ates a demand for labor by its producing. Doubtless it must be ad- 
mitted that not all the demand created by labor's production will 
eventuate in a demand for other labor; since labor's demand for 
goods will be a demand for all the factors necessary to produce 
those goods, land and capital services, as well as labor services. But 
with the majority of commodities, the contribution of labor, direct 
or indirect, is by all odds the most important element. 

There is no intention here of asserting that the process described 
will have no adverse effect. Without doubt it will tend to cause 
some decline in the rate of wages, under the working of the principle 
of diminishing marginal significance. But this result is not to be 
confused with the question of employment. 



XL] WAGES 489 

Employment and Foreign Trade. — One of the most obstinate 
of popular fallacies is the notion that the employment opportunities 
of the people of a community are diminished by carrying on trade 
with other communities, that buying outside takes away jobs from 
one's own people. The unsoundness of this notion was brought out 
in the chapter on the Principle of Reciprocity. In this connection, 
therefore, only a word is needed. Foreign trade is necessarily re- 
ciprocal. If we are buying abroad, we must be selling abroad, — 
must be delivering the foreigner some form of wealth, either goods 
or money. 

But, in producing the commodity or commodities with which 
we pay the foreigner for our purchases, we create opportuni- 
ties for employment just as truly as we should by producing the 
imported goods at home. There are some valid arguments for arti- 
ficially developing certain industries within our own borders ; but 
this "more employment" argument is not one of them. 

Employment Dependent on Land and Capital. — In carrying 
forward the preceding discussion, it was assumed that, in demanding 
goods, the public create an almost equal demand for labor, and, so 
create an almost equal amount of employment. But this presents 
only a partial view of the matter, since production requires other 
factors besides labor. A demand for goods cannot constitute a de- 
mand for the labor needed to produce those goods, unless there are 
land and capital available to complete the combination. It is, of 
course, equally true that a demand for goods does not constitute a 
demand for the land necessary to produce those goods, unless there 
are available labor and capital to complete the combination ; and a 
similar affirmation may be made with respect to capital. In short, 
in a sense each kind of productive goods constitutes a demand for 
the others. Our concern here, however, is with the opportunities of 
labor rather than land or capital. A formal statement of the point 
just made gives us the following: 

Principle. Broadly speaking, satisfactory opportuni- 
ties for employment vary with the abundance of natural 
resources and capital. 



490 PRINCIPLES OF ECONOMICS [XL 

Limits of Possible Employment. — In the preceding discus- 
sion we affirmed the reciprocal dependence of land, capital, and labor 
for opportunity. Rigidly interpreted, this doctrine would suggest 
that there is a definite limit to the opportunities for each of these 
factors, or, for our special purpose, to those of labor. Given a 
certain outfit of natural resources and capital, there will be oppor- 
tunity to utilize a definite amount of labor and no more. Such an 
interpretation would nicely support the popular notion that there are 
just so many jobs, no more and no less, so that giving a job to one 
person necessarily takes one from somebody else. To the trained 
economist, this view seems quite unwarranted. But possibly our 
present discussion may have given it some color of sense. Does not 
the affirmation that land and capital, as well as labor, are essential 
to production support the contention that labor opportunities are 
strictly limited? 

In answering this, we have to remind ourselves that all industry 
is, during some period, in the condition of returns increasable at 
diminishing rate. That is, even if the available quantities of land 
and capital are constant, yet increasing the amount of labor will in- 
crease the total return to the combination, though not proportion- 
ately. Since the increase in return is the contribution in the product, 
which will be credited to the additional labor, and, as such contribu- 
tions will determine the price of labor, it follows that the new 
conditions will lower wages. Still, this will not alter the fact that 
the new labor has found employment. Accordingly, we may say that, 
under ordinary conditions, no one need lack employment if he is 
content to accept that wage which expresses the new marginal pro- 
ductivity of labor. 

As a basis for th6 foregoing argument, it was said that, during 
some period, industry is in the condition of returns increasable at 
diminishing rate. But this basis does not always hold, and so the 
principle laid down calls for qualification. It is possible that in- 
dustry should reach a stage where its returns are substantially fixed, 
where they have reached their maximum ; — even if the efforts of an- 
other laborer could increase the output somewhat, still the additional 
amount would be so small that even with the extremest conceivable 
economy it would not furnish subsistence. Employment is so far 



XL] WAGES 491 

dependent on land and capital, and the possibilities of industry are 
so limited that a time is always liable to come when opportunities 
for employment cannot experience any measurable increase, when 
no more laborers can be utilized. 

Further, in actual life the practical, effective limit to employment 
is usually reached somewhat short of the combination of maximum 
returns. The decline in the marginal productivity of labor does not 
go on till men could live on no less. Rather it stops where they will 
live on no less. In earlier times conquering migration and, more 
recently, peaceful emigration have brought relief ; and in our own 
day improvements in methods of production have repeatedly pushed 
far into the distance the point of maximum returns. 

Employment and the Rivalry of Capital. — We have seen that 
in some sense and to some degree employment opportunities are de- 
pendent on the presence of a large volume of capital. It has to be 
added that the fulfilment of this condition may also bring an un- 
favorable reaction. Capitalistic methods are generally labor-saving 
methods, hence methods which in themselves decrease the need for 
labor as compared with the need for capital. Capital therefore ap- 
pears in some sense the rival or competitor of labor. This fact has 
naturally given rise to much controversy as to whether the intro- 
duction of improved methods does not diminish the total demand 
for labor, (i) All are agreed that immediately certain classes of 
laborers suffer by being thrown out of employment and compelled 
to make new adjustments. (2) Experience shows that, in any given 
industry taken as a whole, there is little, if any, decrease in employ- 
ment; because the lowered price due to lowered cost so stimulates 
demand that the old workers are needed to meet that demand even 
under the new and more efficient methods. (3) The lowered price 
due to lowered cost, if it does not create new demand, releases 
buying power saved because of the lower price, which will be spent 
on new products, save on the almost inconceivable hypothesis that 
goods have become so abundant and their marginal utility so low 
that people no longer want more things. But supplying these new 
products will furnish employment opportunities for the labor dis- 
placed in the old industries. 



492 iPRINCIPLES OF ECONOMICS [XL 

These last remarks would not show that the introduction of 
improvements has no tendency to lower wages by making labor 
relatively more abundant and so lowering its marginal utility. We 
are here concerned only with opportunities for employment at some 
wage or other. 



CHAPTER XLI 

PROFITS 

I 
The Real Nature of Profits 

In the business world, profits were early recognized as a special 
share in distribution, though sharply distinguished from interest only 
when part of the capital was borrowed. This recognition was present 
also in the earlier theoretic discussions. The medieval churchmen, 
who sweepingly condemned interest — usury as they called it — seem 
to have considered profits legitimate, meaning by profits a share 
going to the capitalist who undertook the risks of enterprise. But, 
after economics had come to have some scientific development, 
profits largely failed, especially among the English and American 
writers, to receive any distinct and separate treatment. 

Even when in the middle of the last century the office of the 
entrepreneur began to get attention from English economists, there 
was a singular failure to recognize his true function. He was rep- 
resented as primarily the man who managed productive operations. 
And this happened in countries in which industry was rapidly pass- 
ing into the hands of entrepreneurs who hired men to manage their 
business rather than doing it themselves. This doctrine still shows 
a most astounding tenacity in the texts, though it is manifestly quite 
untenable. The peculiar function of the entrepreneur must surely 
be found in something which he only can do, which he cannot hire 
someone else to do. For anything coming under the latter category 
is plainly labor. Now, the only functions which seem necessarily 
to be left with the entrepreneur, are the assuming of final responsi- 
bility and performing certain types of management which cannot be 
delegated, for example, appointing those who shall direct the 
business. 

493 



494 PRINCIPLES OF ECONOMICS [XLI 

Gross Profits. — Profits, as the term is frequently used by the 
general public, include the whole net return to the responsible owner 
of a business after money outlay has been deducted from money 
receipts. This whole return, which we might call gross profits, 
usually includes at least three elements, (i) wages of some sort, 
principally for management, (2) interest on capital invested, and 
(3) a remuneration for taking the responsibility of production, and 
making certain final decisions which necessarily fall to the owner. 

The first element has come to be eliminated from profits even in 
the popular sense of the term because of the great extension of the 
corporate form of business in which the work of management is 
turned over to hired officials. The second element, interest, is still 
commonly included. That is, stockholders in a concern paying 7 per 
cent dividends would think of the business as yielding 7 per cent 
profit, rather than 4 per cent interest plus 3 per cent profit. In this 
sense, profit is contrasted with interest in being the return to the 
capitalist who bears the whole burden of ownership, waiting plus 
responsibility-taking ; while interest is the return to the capitalist 
who assumes only one part of the burden, waiting. In strict eco- 
nomic analysis, however, profits ought to be limited to the third 
element, the taking of responsibility and making final decisions. 
From this point of view, profits in the illustration above would be 
only 3 per cent, the difference between what the capita] would have 
received if lent to the company and what it actually did receive as 
invested in the business. Profits in this sense, we will call pure 
profits or profits proper. 

Pure Profits. — Pure profits, then, are the remuneration for 
responsibihty-taking, especially for the risk element in responsibility- 
taking. They include an infinitesimal amount of wages, in that the 
owner must make certain final decisions — though in practice this 
tends to become negligible — and perhaps other disutilities or sacri- 
fices. But the chief element in the case is the bearing of economic 
risk. 

Profits Risk a Special Type. — That risk for the bearing of 
which profits are paid must not be confused with the regularly re- 



XLI] PROFITS 495 

curring, calculable losses of a business. Such losses simply increase 
the outlay for labor and capital goods. The remuneration received 
by the entrepreneur because of such losses would never be thought 
of as profits, but only as a fund to replace costs. The risk for which 
profits are paid is the risk of losses which cannot be re^coitped in the 
experience of tJie individual entrepreneur, — risks of total failure, 
or some loss almost as great. Compare the breakage of bottles in the 
brewery business with the chance that temperance legislation will 
destroy the business. The former is covered by greater outlay. The 
latter is a not-to-be-compensated loss. To induce men to assume 
the risk of such a loss, they must be paid something, not of course 
enough to cover the loss if the risk should become a certainty, but 
enough to move their mills to face the possibility of loss. It is thus 
evident that profits must not be conceived as a contribution to an 
insurance fund from which losses are covered. There is no such 
fund; the losses are not covered. 

Profits Under Socialism. — Under Socialism, /the sort of risk 
now remunerated by profits would in the main be covered by an in- 
surance fund; since the state, having a complete monopoly of pro- 
duction, would pool in its own hands all risks, and, as well, all 
chances of occasional gain. The risk cost of production, therefore, 
except perhaps in the case of long-time enterprises undertaken for 
future generations, would become simply more capital and labor cost, 
instead of being as now, the price of the psychological disutility of 
bearing risks. It is probable that the state would charge each com- 
modity with the average cost of the whole output of that commodity, 
including successful and unsuccessful branches of the industry in- 
volved. Profits, as an element of cost, would not therefore be 
entirely eliminated under socialism, but would appear in another 
guise. 

II 

Do Profits Tend to Disappear? 

A noteworthy fact in recent economic discussion is a disposition 
to hold that profits — pure profits — tend to disappear. The argument 
for this contention moves along two general lines. ( i ) It is affirmed 



496 PRINCIPLES OF ECONOMICS [XLI 

that pure profits, assuming them to be paid for risk-taking, will 
necessarily disappear with the elimination of risk from industrial 
affairs ; and such elimination is steadily proceeding through the in- 
crease of knowledge, forethought, and invention. (2) Secondly, 
it is claimed that the disutilities correlated to profits are disutilities 
which plenty of men, especially in America, are quite willing to 
assume without reference to an economic reward. The desire for 
power, the craving for better social standing, and the gambling spirit 
which eagerly improves the opportunity to take chances, — all these 
unite to make men willing to undertake the responsibilities of pro- 
duction, even though they expect to get nothing more than ordinary 
interest on their capital and ordinary wages for their labor. 

Chance Not to Disappear. — In reply to the first of these 
arguments, it seems sufficient to declare that the complete disap- 
pearance of risk, chance, uncertainty from industrial affairs, if not 
quite impossible, is certainly so remote that it cannot properly be 
made the basis for any affirmations with respect to the present order. 
Some centuries hence we may have become able tO' predict the 
weather for a year in advance with absolute precision ; but we shall 
still have to reckon with the uncertainties due to human folly and 
caprice. 

Motives Named Inadequate. — The second argument is less 
easy to answer, yet will not, I think, carry conviction to most persons. 
The first two motives named, the desire for power and the desire 
for social position, affect only a small minority of our entrepreneur 
class, namely, the small individual or partnership entrepreneurs, who 
combine in themselves the functions of capitaHst, manager, and 
entrepreneur. For most of|Our entrepreneurs, belonging to that class 
merely by virtue of being stockholders in some industry organized 
as a corporation, enjoy neither power nor prestige. Under the 
corporate organization of industry, salaried officials are the ones 
who wield power and the social position of capitalists (bond-holders) 
is surely as good as that of stockholders, assuming their investments 
to be equal. But, if there is any large section of the entrepreneur 
class with whom these non-economic motives would not suffice, — 



XLI] PROFITS 497 

who would insist on a greater economic return for taking responsi- 
bility than for simply lending their capital — then, profits would 
surely have to be paid. 

Pure Risk Not Desired. — The third consideration, — the 
gambler's desire to take risks — contains the old confusion of ideas 
which has already been commented on more than once. It is un- 
doubtedly true that men are so ready to take risks, when a possible 
prize is in sight, that they do not aiy a whole class have to be remu- 
nerated for taking that risk. If all the copper producers of the 
world spend 500 million dollars worth of labor and capital getting 
out the product, it is not necessary that the product should be worth 
500 millions plus something for the risks taken. On the contrary, 
that product will probably be worth less than its labor and capital 
cost, say 400 millions. But all this is beside the point. The real 
issue concerns, not the whole class of entrepreneurs interested, but 
only those upon whose conduct depends the output actually supplied, 
the successful entrepreneurs. Do these persons have to get profits? 
Surely they do, else there would not be this gambler's eagerness to 
assume the risks of the business. The proper test for determining 
whether profits as a remuneration for risk-taking really exist, is this : 
Does society have to pay a higher price for a given commodity or 
service than it would have to pay if risk were eliminated? Surely 
there can be but one answer to that question, the affirmative one. 

Ill 

Profits as Affected by Changes in the Value of Money 

In an earlier discussion, it was shown that the value of money 
itself may change, and so general changes in prices may take place 
without reference tO' the conditions ordinarily governing the value 
of each commodity. Thus, under the paper money standard of 
Civil War times, there was a general rise of prices, or, in other 
words, a fall in the value of money, in the United States. So, for 
many years following 1873 there was a general, though gradual, fall 
in prices, — a rise in the value of money, — affecting most or all of 
the western nations. Much more rapid ups and downs mark the 



498 PRINCIPLES OF ECONOMICS [XLI 

periods immediately preceding or following commercial crises or 
panics. 

Common Fallacy. — There has naturally been much debate 
as to how far such movements influence all shares in distribution and 
particularly profits. At first thought one is inclined to say that oi 
course such changes influence profits. If a merchant has paid 
$100,000 for a stock of goods and because of a universal and simul- 
taneous fall in prices, their value declines to $60,000, how can anyone 
deny that the merchant is losing $40,000? This sounds plausible, 
but is in fact an undoubted fallacy. A universal and simultaneous 
fall in prices of 40 per cent raises the buying power of $60,000 till 
it is just as great as was the value of $100,000. Assuming, then, 
that no other element was involved, the merchant in question would 
neither gain nor lose as a result of the general fall in prices. That 
fall in prices does not of itself mean a fall in profits. 

Borrowed Capital. — The above affirmation was qualified by 
the assumption that no other element was involved. But in actual 
life this condition is seldom fulfilled. In the first place, the merchant 
is usually carrying on his business in greater or smaller measure 
with horrozved 'capital. But the sum which he has promised to pay 
when borrowing does not change because the value of money has 
changed. If he is using $20,000 of borrowed capital, he will have to 
pay back, not three-fifths of that sum — $12,000 — but the whole 
$20,000. His debt has not shrunk though the value of his goods has. 
To pay his debt he will need so much of his goods as are now worth 
$20,000, which means so much of those goods as were worth five- 
thirds of $20,000, or $33,000. Hence he has lost the difference be- 
tween $20,000 and $33,000, or $13,000. It follows that, in so far as 
the dealer works upon borrowed capital, a change in the value of 
money causes an inverse change in his profits : If the value of money 
rises he loses proportionately, and if that value falls he gains pro- 
portionately. 

Unequal Rate of Price Changes. — Another element in this 
situation which compels a qualification of our original statement is 



XLI] PROFITS 499 

that general price movements do not take place at an equal rate all 
along the line. Some goods rise or fall more rapidly and more 
promptly than others. In particular, wages do not change as rapidly 
as general goods. It follows that a rise in prices, — a fall in the 
value of money — is likely to redound to the advantage of the dealer, 
in that he gets a larger return from the sale of his goods while his 
expenses for labor have not proportionately increased. And of 
course a reversal of the situation, that is, a general fall in prices, 
an increase in the value of money, works to the disadvantage of the 
dealer for precisely opposite reasons. 

IV 

Profits and the Significance-Disutility Principle 

The attempt to establish the validity of our significance-disutility 
principle for each of the economic shares meets the greatest difficulty 
in the case of profits. As already explained, we mean by profits 
proper the return going to the man who takes the responsibility of 
ownership. We usually distinguish several different sorts, the nature 
of which is perhaps sufficiently indicated by their names. The most 
important are : ordinary, enterprise, speculative, monopoly, and acci- 
dental profits. 

Profits and Significance. — One has no difficulty showing 
that profits are in some sense or degree correlated to a service ren- 
dered, a significance in economic relations belonging to the part per- 
formed by the receiver of the profits. Further, profits are undoubt- 
edly in some sense or degree proportioned to the significance or 
magnitude of the service rendered. Thus, all must admit that those 
persons who initiate a commercially dubious, but socially important, 
enterprise perform a greater service than those who carry on the 
same in later years when success is assured ; and, undoubtedly, the 
profits must commonly be larger for the former persons than for the 
latter. But, admitting a rough correspondence between profits and 
the service rendered, it does not seem possible to affirm quite the 
same degree of correspondence as in the case of wages, interest, and 
rent. 



500 PRINCIPLES OF ECONOMICS [XLI 

Where profits are accidental, the correspondence between services 
rendered and reward received is of course slight. Such profits do 
not tend to express the marginal significance of the receiver's con- 
tribution. 

Monopoly profits doubtless correspond rather closely to the 
marginal significance of the supply of service actually rendered, but 
not to the marginal significance of the supply of service which would 
naturally he rendered. The monopolist, by limiting the output of his 
product, raises its marginal utility, and so its price, above the mar- 
ginal utility which the product would naturally have. In doing this, 
he obviously raises his own profits above the amount which would 
express the marginal utility of his services, were no limitations set 
on their output. 

One qualification must, however, be added. The monopoly which 
temporarily exists may have been anticipated, and may have been 
one of the necessary conditions which induced capitalists to under- 
take the industry in question. Hence we may say that the monopo- 
listic output is after all the natural one and so that monopoly profit 
comes fully under the service-value principle. Cases of this sort are 
supplied by the legal monopoly of patents, copyrights and franchises, 
and by the quasi-monopoly of new enterprises. Here the extra profit 
does not correspond merely to the higher valuation by supra-marginal 
buyers of the service rendered, but also to the additional service. 
For, surely, there is an additional service when men undertake to 
try out the feasibility of a new enterprise, — giving the public an 
opportunity to see the real utility of the service or commodity which 
the enterprise supplies. 

Yet in spite of this qualification of our first statement, economists 
are not generally disposed to affirm the service-value principle for 
monopoly. The presence of monopoly at any point more or less 
seriously interferes with the realization of the principle. Hence, 
assuming for the moment that the principle is a good one in an 
economic order, then monopoly, if necessary or permitted, ought to 
be regulated or controlled in the public interest. 

The argument for enterprise profits has been more or less antici- 
pated in the preceding paragraphs. Such profits somewhat resemble 
prizes. Many persons get nothing ; a few get large rewards. Under 



XLI] PROFITS 501 

these conditions, we can scarcely expect profits to express with great 
precision the contribution of the profit-receiver. Yet we should not, 
on the other hand, imagine that the two are entirely divorced. Op- 
portunities for exploiting novel enterprises are constantly arising; 
competition for such opportunities is kept fairly brisk; the goods 
produced must command prices expressing their marginal utility; 
the marginal contributions of the other factors are at the same time 
being more or less fully determined in other fields ; and it seems not 
unreasonable to assume that the residuum of product — which consti- 
tutes profits — is properly credited to the entrepreneur as his con- 
tribution. 

That ordinary profits, if they exist at all, tend to express the 
marginal significance of the entrepreneur's contribution, seems to 
need no further discussion. Here the elements of change and un- 
certainty are reduced to a minimum ; so that the economic processes 
which tend automatically to secure each factor a share representing 
its contribution to the joint product, meet little hindrance. 

Profits and Disutility. — We have seen that the significance 
half of our principle does not very clearly dominate profits. How 
about the disutility part? It seems plain that disutility would have 
little influence on accidental or monopoly profits. Ordinary profits, 
however, it would seem, must express with fair precision the mar- 
ginal disutility of supplying the entrepreneur service. First, the 
demand of the public must insure for a product a price high enough 
to cover the disutility undergone by the entrepreneur; since other- 
wise production will cease, supply will fall ofif, and so price will rise. 
Second, the competition of entrepreneurs will keep price from going 
higher than the above point ; since their numbers can be recruited 
at all times from those capitalists who merely furnish waiting 
power, who lend their capital rather than invest it. 

In the case of enterprise profits, also, correspondence between the 
disutility and its reward seems necessary from the same reasoning, 
though here the correspondence is less precise. The objection is 
sometimes raised that there is too much chance in these cases to 
insure any particular result. Thus the price of a product may fail to 
cover, not only the peculiar disutility of the entrepreneur, but even 



502 PRINCIPLES OF ECONOMICS [XLl 

the ordinary outlay for material, wages, and capital; while on the 
other hand, it may cover all that outlay and give a surplus large 
enough to insure almost any conceivable risk several times over. 
This reasoning quite fails to recognize the real nature of the re- 
sponsibility-taking disutility. It consists, not of a chance of loss to 
be covered by insurance, but of a chance of loss not to be covered 
at all. To induce men to incur that disutility, a prize or bonus, of 
larger or smaller magnitude, must be attainable in the event of 
success. The size of that bonus is roughly proportioned to the risk, 
though the unit of variation is very different for different races ; 
and, having been fixed, it must be covered in the price of the product. 

Illustrative Problems 

1. "Profits are the wages of management." Criticize. What is the 
test of whether any particular function is an entrepreneur's function — 
whether it is something for which profits are paid? What in the nature 
of the corporation as a form of business association makes "management" 
particularly inapt as a description of the peculiar function of the entre- 
preneur ? 

2, "Profits constitute nothing more than an insurance fund to cover 
the possible losses of the entrepreneur," Criticize. 



CHAPTER XLII 

CRITIQUE OF EXISTING SYSTEM : INTRODUCTORY 

I 

A Critique of the Existing Order a Legitimate Task of 
Economic Science 

In the opinion of not a few persons, we have now reached the 
end of our proper task ; we have covered the whole field which can 
be legitimately included in a purely scientific study of Economics, — 
the analysis of the existing economic order in respect to structure and 
functions. To go further and undertake to pass judgment on the 
satisfactoriness of the existing order, seems to these persons a plain 
transcending of our proper sphere. The title of the present chapter 
shows that the writer does not share that opinion. I consider it a 
very important part of the economist's task to study the present 
order in respect tO' its fitness or unfitness to realize the ends for 
which it must be presumed to exist. 

Argument. — My principal reasons for holding this opinion 
are as follows : First, in dealing with the existing economic order, as 
with any structure to which the term "organism" can be applied, the 
most strictly scientific study — one which has no other end than a 
really adequate knowledge of the facts — cannot properly omit a 
consideration of the fitness of the several organs to perform well 
their respective functions. What physiologist, after determining the 
function of some bodily organ, would consider his task completed 
until he had made an attempt to learn the degree of efificiency at- 
tained by the organ in performing its function ? 

But the study of the working fitness or unfitness of the present 
economic organism has another and more practical justification. 
That organism, in both structure and function, is to a considerable 

503 



504 PRINCIPLES OF ECONOMICS [XLII 

extent the product of consciously free arrangement. At many 
points, it is what it is because we make it so. Doubtless, this aspect 
of the matter can easily be exaggerated ; the power of individuals 
or of society as a whole to alter the system in fundamentals can be, 
and commonly is, overstated. But, so long as this power exists in 
even a small degree, the student of economics is surely called upon 
tO' consider the fitness of the system, as at present constituted, to 
attain its proper ends. For where he finds it fit, he will wish to exert 
his power in support of it, and where he finds it unfit, he will wish 
to have it changed. 

Rival Candidates for the Task. — It may be objected that, 
while we have here a problem which imperatively calls for solution, 
the task is after all one which does not properly fall to the economist. 
The solution, of course, requires economic data; but the problem 
itself is essentially an ethical or political one. Logical consistency, 
therefore, requires that the economist, while furnishing the needed 
data from his own science, should leave the problem as a whole to 
the men who can claim to be authorities in ethics or politics. There 
is no doubt some force in this contention; but it does not seem de- 
cisive. First, we must always remember that there is a degree of 
deference to logical consistency which spells pedantry rather than 
any practical good. Secondly, there are many problems in which 
elements from different fields of study are closely commingled ; and a 
person who undertakes to solve these problems must weigh and 
pass upon the elements from every field. This means that such 
person must transcend in some measure the strict boundaries of his 
subject. But, if none of the persons interested can make an abso- 
lutely legitimate claim to the task, it would seem reasonable to turn 
it over to that particular one whose science furnishes the larger 
number and the more difficult of the data necessary to a solution. In 
the case before us, this condition is most certainly realized by 
economics. 

Superior Claims of Economics. — Economics, then, would 
seem to be the science which would naturally essay the task of ascer- 
taining how far the present economic order is fitted to attain the 



XLII] CRITIQUE OF EXISTING SYSTEM 505 

ends for which it must be presumed to exist. We do not mean to 
suggest that moraHsts, sociologists, et al., should be stopped from 
discussing this subject, but merely that economists can also discuss 
it, and perhaps with more propriety than any other group of thinkers. 
In further support of this contention we may remark that such prac- 
tice is, on the whole, in accord with the best traditions of our science. 
Economists of standing, whatever their initial professions, have 
rarely failed to comment upon the workings of our system from the 
teleological standpoint and even to argue for or against proposed 
changes. 

And it is probable that the instructed public give more weight 
to the verdicts of economists regarding such matters than to those 
of any other class. 

II . 

The Question at Issue 

In the preliminary account with which this course began, the 
existing order was represented as a coherent, rational whole, a 
system having different parts devoted to different functions, all co- 
ordinated into a great harmonious totality. At the same time, we 
saw that the organizing and regulating of this great totality was not 
conscious, but spontaneous, automatic ; and that the particular eco- 
nomic process having most part in creating the great whole and 
regulating its operations, is exchange, and especially that element in 
exchange which we know as value, price. We explained, further, 
that it is price chiefly which determines what things shall be pro- 
duced, how things, when produced, shall be utilized, and what pro- 
portion of the total product shall fall to the different participants in 
socialized production. In the present and succeeding chapters we 
try to answer, not exhaustively, but with greater fulness than here- 
tofore, the question : 

How far is this automatically regulated economic system a suc- 
cess in attaining the ends for which it exists? Does it accomplish 
in a fairly adequate manner its special task: namely, providing for 
the satisfaction of human wants in so far as this is dependent on 
economic goods f 



5o6 PRINCIPLES OF ECONOMICS [XLII 

III 

Verdict of This Text 

Favorable. — In view of the tone of many previous allusions 
to this question, it is hardly necessary tO' say that the answer here 
offered is on the whole an affirmative one. Broadly speaking, we 
look on the existing economic order as measurably realizing the 
ideals which, considering the limitations of human nature, it is 
reasonable to demand from such a system. 

Disclaimer. — But in taking this position we wish to disclaim 
in the most emphatic language any intention of representing the 
present order as a perfect one, either theoretically or practically. 
Its ideals are below the highest, though necessarily so as we think; 
and its practice is at many points far below its ideals. Many of its 
failures grow out of the limitations of human nature ; but not a few 
are needless — can be avoided. Increased interference with the 
actual working of things, both through private and governmental 
initiative — if for no other purpose than to eliminate elements which 
are, and always have been, inconsistent with the system — is impera- 
tively demanded. Further, there can be no doubt that a degree of 
governmental interference going much beyond this, and limiting 
sharply the free working of those conditions which are most char- 
acteristic of the present order, ought to be, and will be, forthcoming 
in the near future. Whether in the interest of society as a whole or 
of those individuals on whom the existing system presses too hardly, 
we shall doubtless see a more extensive resort to governmental 
initiative, a greater limitation of the rights of property, a further 
restricting of the rights of inheritance and bequest, a distribution of 
tax burdens far more favorable to the poor, public provision for old 
age pensions, and so on. 

System in Main Outlines Satisfactory.— In a word, when 
we defend the existing order we merely mean to affirm that that 
order is in its main oMtlines substantially sound, fitted to attain the 
reasonable ends for which such an order exists. Looked at broadly, 



XLII] CRITIQUE OF EXISTING SYSTEM 507 

it shows itself to be highly efficient and as much in accord with our 
moral ideals as we could expect in view of human weakness, folly, 
and wickedness. The general plan of exchange-cooperation, in- 
volving private rather than public initiative, characterized by private 
property in capital and, for most purposes, in land, with production, 
consumption, and distribution regulated in general through a price 
resulting from free economic action, is more likely than any funda- 
mentally different scheme to work in a measurably satisfactory 
fashion. Increased regulation and a more liberal admixture of 
socialistic elements may improve things ; but the general system, the 
main framework, is sound and, as human affairs go, fairly adequate. 

IV 
Distribution Logical Starting Point of Critique 

What Wants Constitute the Economic End? — In attempting 
to answer the general question concerning the satisfactoriness of 
the existing order, we begin a critique of that order in respect 
to distribution. The reason for this should readily be understood. 
Men's wants lie at the root of any economic order; and, presum- 
ably, the satisfaction of men's wants is the object of such an order. 
The ultimate test of an order, therefore, must be its success in 
satisfying these wants. But the phrase "men's wants" is ambiguous. 
Not all wants, surely, can be satisfied. As between lesser and 
greater wants, in the case of the individual, the satisfaction of the 
latter must take precedence. As between different individuals, we 
might set up any one of many standards. Thus, we might rate the 
importance of wants according to their absolute magnitude, sup- 
posing it possible to ascertain this. That is, we might treat any 
want, whether that of a person contributing much to the general 
advantage or contributing little, as having an importance exactly 
proportioned to its intensity. Again, we might recognize the total 
wants of every person as having equal importance with the total 
wants of every other person. Still again, we might treat the wants 
of different persons as having very different degrees of importance, 
according as the part played by these persons in economic matters 
is of little or of great importance. And many other standards rmght 



5o8 PRINCIPLES OF ECONOMICS [XLIl 

be imagined, determining just what are the wants which we have 
in mind when we declare that the end of economic action is the satis- 
faction of "men's wants." 

Function of Distribution to Answer. — But, not only is the 
phrase "men's wants" an ambiguous one, needing definition before 
we can proceed to pass judgment on the fitness of an economic 
order tO' accomplish its task — providing for the satisfaction of those 
wants, — the process by which this defining is done, the process by 
which society determines what are the "men's wants" that should be 
satisfied, belongs to that part of economics which zve have called 
distribution. We could, indeed, conceive an economic order in 
which the state directly determined the importance of dififerent 
wants and directly provided for their satisfaction in accord with that 
determination. Such a system has been tried more or less ade- 
quately at different times, and is usually designated communism. 
It is more or less fully illustrated in the life of the family. But the 
present economic order, as also the much-advocated system of 
socialism, solves the problem by authorizing a system giving to 
each individual a certain money income which he uses to buy the 
commodities or services which constitute his real income. In doing 
this, the state determines the relative importance of the total wants 
of each individual over against other indiznduals and leaves the 
determination of the importance of the different wants of the in- 
dividual to be settled according to his own ratings. 

Hence Distribution Our Starting Point. — But, if the good- 
ness of an economic order must be judged by its fitness to secure the 
fullest possible satisfaction, in their proper proportion, of that body 
of wants which society has decided are the ones that ought to be 
satisfied, and, if such deciding by society is effected by maintaining 
a particular system of distribution, it follows that said system is the 
necessary starting point of any critique of the economic order in 
question. Once we have determined whether the system of distri- 
bution is or is not reasonable, the rest of our task is comparatively 
easy. The remaining parts of the economic order are good or bad 
according as they do or do not contribute to the realization of the 



XLII] CRITIQUE OF EXISTING SYSTEM 509 

ends implicitly approved in the system of distribution, — according, 
in short, as they are or are not consistent with, complemental to, 
the system of distribution} 

Qualifications. — This broad statement of the matter doubt- 
less needs various qualifications. Certain public or group wants are 
not provided for in the system of distribution, at least as v^e have 
treated it. But this qualification is manifest ; and the state has no 
difficulty making its wants supersede all others, either by coming 
on the market wnth a buying power vastly exceeding that of any 
individual, or by the exercise of its absolute sovereign authority. 

Another qualification is needed because the government, believ- 
ing that it is desirable to modify in some particular the working of 
the system of distribution and despairing of being able to do this 
by direct means, may make use of its power to guide the employ- 
ment of social resources in order to accomplish its object by indirec- 
tion. Thus, as was noted quite early in our study, a characteristic 
feature of the present order, in its actual working, is the govern- 
mental practice of producing certain necessaries and supplying them 
to the public either gratuitously or at co price below what would be 
possible under prizj\a\te initiative. 

In spite, however, of these and other possible qualifications, the 
soundness of the general proposition laid down above is incon- 
testable. The system of distribution prevailing at any moment must 
be interpreted as embodying the decision of society in respect to the 
body of wants to be satisfied through the working of the economic 
order, and therefore embodying the decision of society as to what 
are the true social "wants arranged in the order of their importance. 
If following the guidance derived from this system of distribution 
results in what seems, on other grounds, to be a wrong use of our 
resources, this must be viewed as an indictment, not of the process 
whereby production is regulated, but rather of the system of dis- 
tribution which society has authorized. If amendment is needed, 



* This argument, when combined with that of the present and follow- 
ing chapters defending the present system of distribution, has been objected 
to on the ground that it involves circular reasoning. This objection will 
be commented on in Chapter XLVI. 



510 PRINCIPLES OF ECONOMICS [XLII 

that amendment should, with few exceptions, he directed to the 
alteration of the source of the trouble, the system of distribution 
itself. Accordingly, our critique of the present economic order be- 
gins with a consideration of the reasonableness of the system of 
distribution embodied in that order. 



CHAPTER XLIII 

CRITIQUE OF PRESENT PRINCIPLE OF DISTRIBU- 
TION 

The general principle underlying the present system of distribu- 
tion, it will be recalled, runs somewhat as follows : 

When competition is free, each individual tends to get approxi- 
mately that income which expresses the marginal significance of the 
natural supply of the type of contribution made by himself or his 
property to the sum of utilities, and which, at the same time, ex- 
presses approximately the net marginal disutility involved in making 
that contribution. 

Is this principle, on the whole, wise and just? 

No adequate answer to this question can be made without con- 
trasting the principle to be judged with possible substitutes. It will 
perhaps be best, therefore, to begin our critique by examining some 
of the more plausible substitutes that have been suggested, reviewing 
their merits, and, if such exist, their logical and practical defects. 



Proposed Substitutes 

To Each According to His Need. — One principle of dis- 
tribution often highly commended is that which we try to realize in 
family life, as also in the life of the state during periods of greatest 
social exaltation. I mean the principle that each shall receive of the 
common income in proportion to his need, — having given in propor- 
tion to his capacity. This seems to have been, and tO' be still the 
formula of the highest type of communism. "From each according 
to his capacity; to each according to his need." 

To the present writer there seems no room for argument as to 
the ethical superiority of this distributive ideal over all others. If 

511 



512 PRINCIPLES OF ECONOMICS [XLIII 

human nature were capable of maintaining it, no other formula 
would deserve a moment's consideration. But unfortunately there 
is reason, and perhaps quite conclusive reason, to doubt the suffi- 
ciency of human nature in this regard. Even those few hundreds of 
people who succeed in living somewhat near such an ideal in Amana 
and other communistic associations admit that their very limited 
success is made possible only because of certain intense religious 
sentiments which are common to all the members. And no one 
seriously believes that uniform sentiments of this kind exist, or can 
ever possibly exist, in more than a small minority of the hundred 
millions of men, women, and children whO' constitute the population 
of the United States. 

Labor Ideal. — Another ideal which seems to have been more 
or less consciously held by many socialists of the earlier type, is that 
each person should share in the j'oint income in proportion to his 
labor. This of course can be differently interpreted. One may 
have in mind the sacrifice made or the results accomplished. And 
he may conceive the sacrifice as measured in a subjective standard or 
as measured in an objective one, like time. 

In general, the socialists seem to have had in mind primarily the 
sacrifice of labor as measured by the time spent in applying it. Yet 
they tried to avoid divorcing this completely from results, by in- 
sisting that the labor must be labor which produced things, and 
standardised labor at that, — labor which in the given place and time 
was "socially necessary" to accomplish the result. Marx ^ further 
conceded that we could not treat all kinds of labor as exactly the 
same, though he would not admit qualitative differences. The labor 
of the artist and that of the mechanic must be treated as differing in 
intensity, or density, so to speak. That is, one hour of the artist's 
labor should be reckoned as the equivalent of, say, three of the 
mechanic's. 

The labor ideal as thus interpreted, though not without points of 
merit, has fundamental defects which render it unworthy of ex- 
tended discussion. Any scheme of distribution which can reason- 



* The most eminent of the theorists who laid the foundations of socialism. 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 513 

ably ask for society's favor must in serious measure make economic 
reward conditioned upon economic signiHeance, must make differ- 
ences of economic reward correlative to differences in economic 
significance. This Marx tacitly admits by refusing to reward labor 
which produces nothing useful, and by insisting that all labor must 
be standardized, reduced to "socially necessary labor." But differ- 
ences in the economic significance of the several kinds of labor often 
show no correspondence either to labor time or to labor intensity. 
It is therefore quite out of the question that labor as measured in 
labor time, even when corrected for intensity, should be accepted as 
the principle of distribution. 

Social Service Ideal. — Another conceivable ideal of distribu- 
tion, more or less definitely held by many intelligent people, may be 
called the social service ideal. This idea differs from the one em- 
bodied in the present order in that, under the latter, each person 
receives a price which expresses the significance of his services to 
individuals graded according to the buying pozver they possess; 
while, under the social-service principle, a man would be paid ac- 
cording to the significance of his services to the group as a whole or 
to all individuals withoufany reference to their wealth or poverty. 

This ideal has at the first hearing an extremely plausible sound. 
There- is something particularly obnoxious in the fact that, under the 
present system, the power to furnish services of a very trivial sort, 
or even services highly immoral in their character, enables the 
owner to command a large income, because persons desiring such 
services chance to possess great buying power. It would seem much 
more equitable that one's income should depend upon the services 
of real worth which he renders direct to the humanity which is in 
all men alike, or to the worthiest needs and demands of the entire 
social group. 

But further examination shows this principle to be seriously 
deficient. First, in so far as it concerns the group as a whole, the 
new principle is already contained in the one which governs our 
present system. The group is fully organized and, through the use 
of the sovereign power of taxation, can insure that group wants are 
satisfied at whatever cost, — can see in other words, that men are paid 



514 PRINCIPLES OF ECONOMICS [XLIII 

in accord with the importance of the service they render to the 
group. 

Secondly, the proposed ideal, as applied to individuals, is self- 
contradictory. For a principle of distribution simply cannot pay 
according to the importance of the service rendered without paying 
according to the importance of the service to individuals graded 
according to buyitig power. ( i ) Since men are to be paid in accord 
with services rendered, they are to be paid unequally. (2) This 
means that the effective demand for commodities and services will 
be unequally distributed. (3) But the distribution of effective de- 
mand will, necessarily determine in what proportions people will 
actually consume goods. (4) But the only importance which can 
signify anything is importance to actual consumers. (5) It follows, 
therefore, that to pay for services according to their importance to 
individuals without discrimination as to wealth or poverty, is to pay 
for those services in accord with their importance to persons who 
do not get them at all, — a process which really amounts to paying 
for services without regard to their importance. 

Equality Ideal. — The last ideal of distribution which we 
shall here discuss is that of equality. To- each an equal share, but 
from all, service, is its motto. This is the more usual communistic 
ideal, and it is apparently favored by many socialists. Nor can 
we wonder at its popularity, for^there is indeed much to be said in its 
support. The greatest discomfort from poverty — not the absolute 
want of the poor, but their contrast with more favored neighbors, — 
would, under such a principle, be overcome. Further, equality 
would not fail to bring a degree of satisfaction to many people, 
those who descended as well as those who rose, even if the equality 
were one but little removed from misery. 

But, after all, this principle is quite impracticable. Equality in 
income, though serving well various sentimental considerations, 
would sacrifice to these the real, material welfare of all classes. 
Further, it would not even embody the ethical ideals which dominate 
practically the whole community. For, however people may feel 
toward interest, rent, and profits, they almost universally believe 
that wages and salaries ought to bear some relation to service. 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 515 

Need for Inequality, — But the subject is too important to be 

so lightly disposed of. Are we right in saying that an attempt to 
enforce complete equality would sacrifice the real material welfare 
of all classes to mere sentimental considerations? In support of 
this view, there are three chief sets of facts. 

Efficiency in Important Functions. — In the first place, giving- 
some persons larger incomes than the rest of us may be directly 
required in the interests of the rest of us, in that the larger incomes 
are necessary to enable those persons to perform efficiently the im- 
portant tasks tve have assigned them. Thus no thoughtful person 
would contend that the people of the United States could aflford to 
have their chief executive live on $1,000 a year, even if he were 
perfectly willing to do so. To perform at all well his services to the 
people of the nation, he must spend, on matters more or less per- 
sonal in their nature, many times $1,000. What is true of the presi- 
dent of a great republic is true in only lesser degree of hundreds of 
other men. In fact, if we sufficiently narrow the circle of interested 
persons, it is true in a way for almost every male citizen. To the 
other members of his family, it is more important that the bread- 
winner, though the humblest of day-laborers, should be well fed 
than that the rest should be, because only so can he be fit to earn 
the income on which they all depend. But, of course, the point is 
more forcefully illustrated in the greater relations of society. To 
those men whose functions involve large responsibilities, intense 
mental activity, and great* nerve strain, we must, for our own sakes, 
give large incomes, in order that they may prove resolute, clear- 
sighted, well-poised, and in other respects fitted for their great tasks. 

The objector may say that we really have here a case not of 
better income, but rather of collateral expenses. Needs of this kind 
should be provided for as part of the outlay of the office which the 
man holds. If $1,000 is the best income the community can afford 
its members, the president, as a man must be satisfied with that in- 
come; though on his office we may spend $100,000. Doubtless some- 
thing, perhaps much, could be done along this line ; the writer heart- 
ily believes in employing such a policy wherever possible. But the 
whole difficulty could not be met in this way. A need is often so 



5i6 PRINCIPLES OF ECONOMICS [XLIII 

personal, so individual, in character that it cannot be provided for 
save through a fund placed at the disposal of the person interested. 
One person requires one sort of relaxation, perhaps a very inex- 
pensive one ; another requires a very different sort, perhaps a very 
costly one. Further, the employing public (under socialism), whose 
opinion is greatly influenced by persons not in a position to judge 
of the personal needs attaching to the higher social functions, would 
commonly underrate those needs, as is shown in the niggardly sal- 
aries now paid public officials in democracies. In consequence, pro- 
vision for this kind of need, if made in a formal sort of way, would 
probably be far too small. 

Proper Assignment of Factors: Disutility. — The preceding 
paragraph has named one reason why inequality of incomes is neces- 
sary in the interest of the very persons whose apparent incomes 
would be raised by the abolition of that inequality. A second is 
found in the fact that unless incomes are unequal, they will not 
even approximately express the relative sacrifices which men un- 
dergo in contributing different services, and, so will induce an over- 
supply of services which involve small sacrifices and an undersupply 
of the opposite kind. 

This difficulty has always been recognized by the creators of 
Utopias ; and to meet it a great variety of ingenious schemes have 
been devised. Thus, some writers have proposed that conscripts 
from all classes should have to serve a certain length of time in 
objectionable trades. Others have reserved these occupations for 
the convicts. More. recently, we have had much stress laid on (i) 
variations in the length of the labor day and (2) honor rewards. An 
undesirable occupation might be made less unattractive by reducing 
the day from 6 hours to 4, or 3. So, attractiveness might be given 
the occupation by attaching thereto decorations and official rank. 

Now, it seems highly improbable that these devices should have 
anything like the effectiveness which is anticipated from them. The 
honor device, especially, overlooks the fact that honors, to be effec- 
tive as a stimulus to emulation, must not be too commonly employed. 
Gaining a prize is not worth while, if almost all the contestants gain 
prizes. Being a member of an academy which everyone can join 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 517 

by paying $5, will attract people only so long as they are ignorant 
of the facts. But, whether these schemes are practicable or not, 
there can be no doubt that they are inconsistent with real equality. 
Why do I object to my neighbor's having a better income than I, 
supposing mine to be enough for a decent life? Mainly, it is because 
the spectacle of his enjoying advantages which I cannot enjoy de- 
tracts from my peace of mind. Now, what matter as to the source 
of these advantages? To see him watching the great national game, 
or comfortably lying in the shade, while I toil and sweat in the sun, 
would surely awake in me an unpleasant sense of contrast if these 
privileges were granted him as a direct reward for accepting some 
task, just as truly as they now do, when they come as an indirect 
reward for that same service. So, again, one of the greatest objec- 
tions to the inequality of the present order is that it gives tO' the 
men of larger incomes a higher place in the estimation of their 
fellows, better social standing. Will this deeper sort of inequality 
be any less obnoxious when it is directly created than when, as at 
present, it is the indirect result of inequality in money income? 

Proper Assignment of Factors: Significance. — There is still 
a third reason — and this is the weightiest of all — why people gen- 
erally, considered as consumers, must in their own interest prefer 
that some other persons should receive better incomes than them- 
selves. There must be inequality of incomes, some contributions 
must command much higher prices than other contributions, because 
only in this way can it he made certain that society will make the 
best use of its resources, its productive capacities. 

In an earlier discussion it was shown that, in a world like ours 
where different kinds of primary factors, limited in amount and 
capacity, enter in different proportions into the production of differ- 
ent commodities, each of those kinds of factors will have its own 
special significance or importance as determined by its contribution 
to the production of goods. Further, under the present system of 
free private initiative and exchange, insuring that each factor has a 
price which expresses approximately its true significance is accom- 
plished automatically. Now, by some process or other, the same 
task must be performed under any system of economic organization 



5i8 PRINCIPLES OF ECONOMICS [XLIII 

— communism, socialism, or what not. For, otherwise, we could 
have no assurance that we were making the best use of our 
capacities. 

Proper Valuation of Services Necessary. — First, the mere 
assigning to things of their proper prices would be necessary under 
socialism no less than under the present order, as a part of the public 
system of bookkeeping. For, if the state were to become the sole 
landlord, capitalist, and entrepreneur, it would be obliged to carry on 
an elaborate and complete system of bookkeeping in order to have at 
hand the knowledge of conditions necessary to a reasonable conduct 
of economic affairs ; and, in this bookkeeping, the state would need 
to credit each primary factor with the true significance of that fac- 
tor, since, otherwise, it would frequently waste important factors on 
unimportant commodities. In short, whether or not men were 
actually to receive unequal incomes, they would have to be credited 
with unequal contributions. 

Corresponding Income Probably Necessary. — But when each 
person has been credited with the true value of his contribution, can 
it be doubted that, under any system which is in the remotest degree 
practicable, that value, or something approximating it, would have 
to be paid to the man who made the contribution ? We say "under 
any system which is in the remotest degree practicable" ; for one 
might admit that a despotically organized communism, effecting and 
regulating cooperation through authority, could "exploit the work- 
ers" — to use a socialist phrase — could give equal remuneration for 
very unequal services. But surely no communistic plan yet proposed 
is to be taken seriously. We need, therefore, to consider only 
socialism. Would that system of economic organization be driven 
to pay men in proportion to their contribution? 

True Under Socialism. — The answer is surely an affirmative 
one. We could, indeed, conceive a socialist state which at first 
thought would seem able to avoid the necessity of adjusting reward 
to contribution; I mean a state conterminous with the earth and 
organized as a completely centralized despotism. Such a state might 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 519 

seem to be emancipated from all necessity for paying its workers 
according to any standard other than its own will, because competi- 
tion would have been completely eliminated. As a matter of fact, 
however, I doubt if even this vast despotism would be able to exploit 
the capable in the way supposed, and that for two reasons: (i) the 
capable would probably be in power, and (2) whether or not, they 
would know their own importance and, by a refusal to work for less, 
would compel the authorities to raise their pay till it approximated 
the real value of their services. But it surely is wasting time to 
build upon the fantastic assumption of a cooperative commonwealth 
coextensive with the earth and organized as a completely centralized 
(despotism. If we ever have a coUectivist state, it will be one among 
many sovereign states, and one in which local autonomy, municipal 
and provincial, still exists. It will, therefore, be a state in which 
competition still exists. Different municipalities, different common- 
wealths, different sovereign states will more or less vie with each 
other in trying to attain the highest efficiency, and so will drive one 
another into paying the persons who supply the different kinds of 
productive services something like what those services are worth. 
But, in doing this, they will of course make the shares of these per- 
sons in the social income unequal. 

In short, while inequalities in distribution need not always be so 
great as they are today, while they would be much reduced under a 
socialist regime and no doubt zvill be much reduced under the present 
regime — still, inequality of some degree is inevitable. The ideal 
which would give to each citizen an equal share with every other is 
quite out of the question. The remuneration received by each must 
bear some relation to his contribution. 

Summary. — Finally, as a general result of the discussion 
in this entire chapter, what do we have? We have examined all the 
chief substitutes for the existing principle of distribution that have 
been proposed; and while we have found them commendable in 
many respects, and especially as regards their humanitarian purpose 
or intent, we have also found them one and all, on the whole, im- 
practicable, — it is doubtful whether, for the present at least, they 
can be established. This being true, it is virtually certain that the 



520 



PRINCIPLES OF ECONOMICS [XLIII 



existing principle, with possible modifications, will for some time be 
continued. It therefore becomes of the first importance to determine 
whether that principle, since it needs must be endured, is any more 
defensible than these others. To that task we shall turn in the fol- 
lowing chapter. 

II 

Defense of Service-Value Principle 

We have tried to prepare the way for a defense of the existing 
system of distribution, especially in respect to its general principle 
or ideal, by showing the impracticability of the ideals which have 
been proposed as substitutes for the one dominating the present 
order. We now undertake a brief defense of the general principle 
of the existing system, leaving to the succeeding chapter a defense 
of the more prominent features of the system of distribution that 
appear in the working out of its principle. 

Service-Value Principle Necessary. — That, under any social 
order which retained any degree of individual liberty and local 
self-government, the acceptance of the service-value principle or 
ideal would be practically necessary in the interest of mere economic 
efficiency, — has already been established in showing the impossi- 
bility of the equality of the ideal. Even under socialism, we should 
be driven to pay men for their services in substantial accord with 
the effective importance or value of those services; for only so 
could we assure the assignment of those services to their proper 
tasks. We shall now comment briefly on special objections to the 
dominance of this principle. 

Generic versus Specific Utility. — There appears among 
many people a disposition to criticize the ruling principle of distri- 
bution because it pays men in accord with their effective or specific 
utility rather than their generic or class utility. Thus, the utility of 
coal miners as a class is surely far greater than that of high-grade 
singers as a class ; but society pays a miner for an hour's work, per- 
haps, 40 cents, while it pays the singer for an hour's work, perhaps, 
$2,000. This objection always arouses a sympathetic response in the 
popular mind ; but to the student who has acquired a fuller compre- 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 521 

hension of economic relations, it is quite without point. A person 
who puts forward this objection really admits by implication that it 
is right to have men paid in accord with the importance of their 
serz/ices; he only complains that we set the wrong standard for judg- 
ing importance. But his complaint is of course a mistaken one. The 
real importance of any man is his effective importance, — what we 
should lose if we lost him, not what we should lose if we lost his 
whole class. For usually the alternative facing us is, not keeping 
or losing the whole class, but keeping or losing an individual of the 
class. 

And what we lose by losing any individual of a class is only 
the utility of the least useful of the class, since the loss of any 
higher utility would be avoided by transferring the least important 
member of the class from his present task to the higher one. 

One's Own versus Marginal Utility. — Another familiar ob- 
jection to the service-value principle is that it pays a man, not in 
accord with his oinm specific utility, but in accord with the utility of 
the marginal member of his class. Thus, a man may be performing 
some service for which his employer is glad to pay him, and does pay 
him, $2 a day; when, without any fault on his part, an increased 
supply of labor comes on the market and lowers the marginal utility 
of his class to $1.50 per day, with the final result that, though still 
performing the $2 service, he now gets only $1.50. Viewed from 
this man's standpoint the situation naturally makes a powerful 
appeal to one's sympathies. But what about the incoming man? 
He surely cannot be paid more than the $1.50 which he really earns. 
But, if the first man continues to get $2, while this second one who 
is working just as hard and is perfectly able to replace the former 
gets only $1.50, our sense of justice would be outraged just as much 
as in the former case. 

But, again, the objection is quite untenable logically. As we said 
above, if a man is to be paid in accord with his importance at all, 
the importance in question must be his real, effective importance. 
But the real, effective importance of a man is determined, not by the 
importance of the thing he accomplishes, but by the importance of 
the thing which the m^arginal member of his class accomplishes. 



522 PRINCIPLES OF ECONOMICS [XLIII 

Justice versus Mere Economic Value. — Probably the mis- 
giving which most persistently recurs to all of us concerning the 
service-value principle, is that to defend or even patiently accept it 
one must be somehow too cold-blooded, too insensible to considera- 
tions of sympathy, humanity, love of one's fellows. When one is 
exercising his logical faculties on mere abstractions or is dealing 
with mere things, he can recognize the working of an inflexible 
scientific principle without a qualm. But here the interests at stake 
are the incomes and, therefore, the happiness of living human beings. 
Is there not something inherently shocking to our moral sense, even 
to our sense of mere decency, in the advocacy or adoption of a 
principle which places interests like these at the mercy of so unmoral 
a thing as the law of supply and demand, or the law of marginal 
utility? Does not every right-minded man respond with full ap- 
proval to the belief expressed by Mill that a time will come when the 
division of society's product, instead of being a matter of automatic, 
mechanical, regulation, "would be made by concert on an acknowl- 
edged principle of justice f' In fact, is not this whole attitude of 
mind which conceives human beings as mere instruments, mere 
things, inherently wrong? Must we not rather at all times con- 
ceive human beings as ends in themselves? 

Now there is surely some force in all this. We saw in the pre- 
ceding chapter that it is at least possible to imagine a principle dif- 
ferent from, and higher than, the one now operative. We believe 
also that the working of the principle in the actual order can be 
greatly improved by changes which would better satisfy the de- 
mands of moral and humanitarian sentiment above alluded to. And 
we believe that its worst tendencies could be, and are, not a little 
offset by a secondary distribution through voluntary benevolence 
and the use of the taxing power, — all this in obedience to the same 
moral and humanitarian sentiment. But, when all is said and done, 
we can only imagine a radically different system — not really estab- 
lish it. We can only modify the working of the present principle, 
not overthrow it; we have no choice but to submit to the principle 
as it is. Whether the principle shocks our sentiments or not, there- 
fore, the least we can do as scientific students is frankly to recog- 
nize its reality. 



XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 523 

But in fact there is no good reason why the existing principle 
of distribution should offend our moral sentiments. Rather, the 
contrary. If the service-value principle is the only one which can 
sustain society from falling into the poVerty and misery of com- 
munism, then it would not be difficult to make out a case showing 
the principle to be positively humanitarian. Nor need we, in the 
second place, feel too keen a response to the notion that it is wrong 
ever to conceive of human beings as functioning in some relations 
like mere instruments or things. 

There is nothing per se unworthy or degrading in taking one's 
turn at being a mere thing in economic society. Doubtless we all 
ought to have our opportunity to live for living's sake, to be ends 
rather than means. But this is perfectly consistent with our being, 
much of the time, mere means to an end. Further, it is quite easy 
to overstate the case. Men are prone to overemphasize their right 
to be "ends in themselves." Most men of mature years have learned 
that, in the long run, scarcely anything is really worth while, even 
from the purely selfish standpoint, except to set oneself a suitable 
task and endeavor conscientiously to perform it.^ 



^ By a curious inconsistency, people who emphasize this objection seem 
to have no sensitiveness on the matter, provided the station in which one 
serves as a mere means is sufficiently digniHed. We hear nothing in this 
vein when they are speaking of doctors, lawyers, professors, politicians, and 
others of the higher classes of workers, though of course these persons are, 
on the professional side, mere instruments, mere things, just as truly as the 
common laborer. 



CHAPTER XLIV 

THE PROPERTY INCOMES INDESTRUCTIBLE 

In the preceding chapter we defended the general principle or 
ideal of distribution embodied in the present system, as being 
necessary to social welfare, and, on the whole, reasonable and just. 
But this leaves much of our task unaccomplished. The service- 
value principle might be all right, abstractedly considered ; but it can 
he realized only under a concrete set of conditions. It must work 
itself out through definite institutions, legal prescriptions, customs, 
economic laws, and so' on. As thus working itself out, is it de- 
fensible ? The conditions in question, as we know, are very numer- 
ous and complex. To cover the whole matter thoroughly is of 
course quite beyond us. We must content ourselves with some 
consideration of the most important points. 

Primary economic distribution, as we have seen, depends chiefly 
on the kinds of shares or sources of income which are permitted 
and the natural laws determining the volume of these shares. The 
former of these two conditions depends largely on mhat kinds of 
property are permitted: especially whether private persons may. or 
may not own capital or land. The latter is the general principle of 
distribution we have already considered. We shall consider mainly 
the legitimacy of the shares or sources of income by which primary 
distribution is determined, more especially the three property 
incomes. 

As preliminary to the defense of the existing system, I propose 
to use the present chapter to show that the three incomes in question 
are indestructible. They cannot be eliminated; and they must af- 
fect the distribution of the total social income whether we believe 
in them or not. We may alter their destination, but we cannot 
annihilate them. In making the argument for this point, I shall 
assume the existence of a socialist order; since, if these incomes 

524 



XLIV] PROPERTY INCOMES INDESTRUCTIBLE 525 

are bound to exist under such an order, few will doubt the propo- 
sition that they will continue under any order. We will first take 
up the case of rent. 

I 

The Maintenance of Rent Inevitable 

That rent would necessarily continue to exist under any eco- 
nomic order, supposing the condition necessary to create it — the 
inadequacy of the land to meet the need for it — to continue, is a 
proposition from which there is little, if any, dissent. Economists 
are apparently agreed on the point ; and even the reformers who 
deny the legitimacy of a system which permits private persons 
to appropriate this income, usually admit that it must exist, though 
they would transfer it from private landowners to the state. The 
reason for this unanimity is plain. Rent is a surplus arising, not 
through any act of man, but through the fact that the natural 
amount of land and its capacity to assist in the production of 
commodities is so limited as compared with the demand for those 
commodities that the latter necessarily have a value greater than 
their costs other than rent, and so a surplus is created. By no 
conceivable process can that surplus be destroyed, though, of 
course, its destination can be altered. 

Objection. — But it is possible that someone might be in- 
clined to demur from this matter-of-course settlement of the ques- 
tion. "Whatever may be the ultimate condition necessary to 
create rent," the objector may say, "the condition immediately nec- 
essary is the existence of high prices for land products, prices 
higher than costs of production on the rent-bearing lands. But, 
under socialism, prices are things to be fixed by the government. 
Would it not be possible, therefore, fo'r government to destroy rent 
by so changing the prices of land products as to destroy the sur- 
plus from which it springs? Thus, if the government were to fix 
for each parcel of wheat a price exactly equal to the cost of that 
parcel, instead of having just one price high enough to equal the 
marginal or greatest cost, there would be no surplus and so no rent." 



^26 PRINCIPLES OF ECONOMICS [XLIV 

Answer. — This sounds well ; but it will not hold. The pro- 
posed policy would not destroy the surplus, but merely transfer it 
from the landlord — under socialism, the state — to consumers of 
those parcels of wheat which were raised on better lands.^ If the 
marg'inal portion of the wheat crop costs $2 and continues to be 
produced and sold, it must be worth $2. But, if the marginal 
portion is worth $2, the other portions must also be worth $2, even 
those which cost only 50 cents a bushel. Hence, the government 
which should charge a price of 50 cents for wheat which cost only 
50 cents, would, in effect, make to the buyer of that wheat a present 
of $1.50, that is, would make him a present of the rent on the land 
from which his wheat came. There can be no doubt, then, as to 
the soundness of the common doctrine that rent must exist under 
any economic order as am, income divided in some may among the 
citizens.^ 

II 

The Continued Existence of Interest Inevitable 

• The contention that, under socialism and so under any system, 
interest must continue to exist as an income to be enjoyed by some 
person or persons, — this contention has not been so generally ac- 
cepted as the analogous one with respect to rent; but it seems no 
less certainly true. Interest represents a real advantage, a real 
service, derived from the power to wait, which advantage or service 
has marginal significance or importance because the supply is not 
sufficient to satisfy all needs for this service, and, having marginal 
significance, therefore has value. This being true, only those 
products which had a marginal significance great enough to justify 
their having a value which included an allowance for interest — the 



^ The share going to each of these consumers would, of course, vary 
with the goodness of the particular piece of land on which their parcel of 
wheat was raised. 

* Most advocates of socialism would probably favor maintaining one 
price for wheat and having the state absorb the resulting rent. It is not 
unlikely, however, that a socialist government, which would almost of 
necessity be democratic, would manipulate prices somewhat in order to show 
special favor to the consumers having smaller incomes, — supposing such a 
state to permit income differences. 



XLIV] PROPERTY INCOMES INDESTRUCTIBLE 527 

value of waiting — could legitimately be produced. That isj so long 
as the condition causing interest — the inadequacy of the supply of 
waiting-power to satisfy all the need for that waiting power — con- 
tinued to exist,^ interest would continue to exist. It might be 
hidden, it might be consciously transferred from the owner of the 
waiting power to some one else, it might be ignored ; but it could 
not be eliminated. Some person or persons would necessarily en- 
joy it. 

But possibly someone might bring forward an objection analo- 
gous to that remarked on in the case of rent. If interest under 
socialism would be implicit in the prices of commodities, could not 
the government destroy it altogether through its control over the 
fixing of prices? Thus, if the prices of products were lowered so 
as to cover only the costs other than interest there would be none 
of this interest implicit in prices. Quite true, but not germane. 
It would not be in the price, but it would still be in the value. 
Consumers would enjoy advantages for which they had not paid, 
that is, they would be the recipients of the particular income under 
consideration, interest. Further, the plan would involve much dis- 
crimination in the way in which this income was distributed among 
consumers. Those persons calling for goods in the production 
of which waiting plays a large part would get the lion's share of 
the interest income, the rest would get little or none. Thus, the 
plan proposed for eliminating interest would merely transfer it 
from the state to specially favored consumers. 

Ill 

The Maintenance of Profit Inevitable 

That profit must continue to exist under any economic order is 
somewhat less certain than the analogous proposition with respect 
to rent and interest. Some types of profit now familiar would 



* We are not here concerned with the question whether the situation 
which now insures the existence of interest would continue, but whether, 
even with that situation continuing, interest would necessarily continue, — 
whether, in other words, interest could be eliminated by some arbitrary 
change in the system or in its management? The answer is an emphatic 
negative. 



528 PRINCIPLES OF ECONOMICS [XLIV 

probably disappear altogether. Further, the most important con- 
stituent of profit, the one growing out of risk, would be greatly 
diminished in amount, and what remained would in large measure 
be transformed into other types oi income. As a result, the total 
of what may be called profit in the strict sense would be much di- 
minished. Nevertheless, the share now called profit would have 
its counterpart even under socialism, and, though a portion of this 
would be transformed into other types of income, there would 
remain a portion which retained its own distinctive character. 

The argument for this contention is substantially the same as 
in the preceding cases. Profit corresponds to a service which must 
be performed if production is to go on at all. If we are to have 
meat or clothes or shelter, someone must assume the responsibility 
of producing these, — must use up his goods in the venture, accept- 
, ing, in place of those goods, the resulting product. This function 
might be performed by the government, as under socialism, instead 
of by private persons, as at present. But performed by someone 
it must be. Further, the power to perform this function must ob- 
viously depend on the possession of surplus wealth, capital, and 
so must be limited in amount. No one surely would claim that our 
wealth could ever be so great that we could afford to undertake 
the production of anything men might desire, however great the 
risks of failure. There would always be wants clamoring for at- 
tention, provision for which would be impossible because, with our 
limited resources, we could not afford to take the chances. That 
is, the power to assume the responsibility of production would 
have extra'r-marginal significance and so would have value. In con- 
sequence, if the production of one of two given commodities in- 
volved greater risk than the other, though their costs in other 
items were the same, the one to which the greater risk attached 
would need to have more value than the other to justify its pro- 
duction instead of the other. In other words, there must he am 
element in the value of any product corresponding to, representing, 
the risk taken in its production. That element is the real profit, 
implicit profit we may call it. As a real value the presence of 
which is made necessary by the conditions of the case, its elimina- 
tion is impossible, if production is conducted as it should be, though 



XLIV] PROPERTY INCOMES INDESTRUCTIBLE 529 

its destination can be changed. Thus, as in previous cases, we 
might omit from the selHng price of a given commodity the part 
which would correspond to the profit element just described, and 
it seems probable that many advocates of socialism would favor 
such a procedure. In doing this, however, we should not be de- 
stroying profit, but only making a present of that profit to the 
consumers of the particular product in question. 

The above argument shows that, even under socialism, there 
would necessarily exist an income corresponding in a general way 
to what is profit in the present order. Under socialism, however, 
as was indicated at the outset, a considerable portion of this par- 
ticular income would naturally be transformed into the other types 
previously considered, namely : wages, rent, and interest. The 
reason is as follows : Since, under socialism, the state would be 
the sole entrepreneur, all losses of whatever character would im- 
mediately fall on the state. That is, the existence of such losses 
would merely mean that the total outlay of the sole producer in 
carrying on the industries of the community — ^his outlay in labor, 
natural resources, and waiting-power — had been made just so much 
greater than it would have been if the losses had not occurred. 
Doubtless, there would necessarily be a value, and so an income, 
representing this excess of cost. But such value and such income 
would be assignable, not to some new type of income, but to one or 
more of those previously considered : wages, rent, or interest. 

We have argued in the last paragraph that, though the income 
which now appears as profit would largely survive under socialism, 
it would after all survive, not as a distinct type, but rather as an 
addition to wages, rent, and interest. To this, however, it ought 
to be added that there would probably remain under socialism a 
residuum of profit in the strict sense, an income not capable of as- 
signment to one of the other three. The reason for this is that, 
in the long run, the socialist state would insist on making a charge 
for products sufficiently in excess of probable losses to insure com- 
ing out even ; and, in doing this, the state would take to itself a 
type of income closely analogous to pure profit under the present 
regime, and one which could not be brought under any or all of 
the three other types. 



CHAPTER XLV 

THE PROPERTY INCOMES AS INCOMES OF 
PRIVATE OWNERS 

It has been shown in the preceding chapter that rent, interest, 
and even profit, in some degree, are bound to be present under any 
economic order as incomes enjoyed by someone. This quite ob- 
viously does not prove that they can legitimately be assigned to 
the classes of persons now receiving them. It does not even con- 
tribute any definite argument in support of such a contention. 
Nevertheless, the time spent establishing this point does not seem 
to me to have been wasted. In the first place, this aspect of the 
matter greatly impairs the force of a certain method of attacking 
the legitimacy of the present assignment of the incomes in question 
which has had much vogue in our day. That method consists in 
representing all economic institutions and arrangements as tempo- 
rary, provisional, almost accidental. Capital itself, and of course 
the incomes springing from it, are "historic categories." That is, 
they have no roots in the very nature of things — they have not 
always existed — they are the product of special, social, or legal 
arrangements. Such an account of the matter does not, of course, 
really constitute an argument against the present treatment of 
these incomes; but it has a sort of dissolving effect on the con- 
victions which have been held on these points. If capital, interest, 
and profit are categories representing things altogether temporary, 
things invented and established by man, it is very easy to slip into 
the notion that the particular disposition of these which obtains in 
the present order has no presumption in its favor, that such dis- 
position is purely artificial and arbitrary, can be swept away with- 
out hesitation as having no claim to serious consideration. Against 
such a dissolving doctrine, this text has tried to guard the student 
from the very outset. There is nothing or next to nothing in it. 

530 



XLV] INCOMES OF PRIVATE OWNERS 531 

Capital is not a historic category; interest is not; profit is not. 
With scarcely a shade of exaggeration, we may say that there 
never was a time in the history of civilization when they did not all 
exist. They have their roots in the very nature of things, not in the 
artificial enactments of men. Any weakening in our support of 
the present system derived from the opposite notion is unjustified. 
A second advantage to be derived from the establishing of the 
doctrine that the three property incomes are indestructible, cannot 
be eliminated, though their destination can be altered, is that it 
isolates sharply the real issue before us, that is, the question whether 
or not tne private appropriation of these incomes is legitimate. That 
question we must now attempt to answer. 

Doctrine Here Maintained. — The conclusion on this point 
reached in the following discussion is on the whole favorable to 
the present order. In maintaining that position, however, I wish 
to disclaim most emphatically any intention of affirming that the 
present assignment of the incomes in question is the only reasonable 
or just one. There is no room for doubt that, if society should 
come to believe it expedient to abolish private ownership in land 
and capital, and so to abolish the private appropriation of the in- 
comes derivable from these sources, it would be entirely justified 
in carrying out such a policy. There are no private claims so 
sacred that they can stand against the claims of the general wel- 
fare. Again, I wish to disclaim any intention of affirming that all 
of the three property incomes and all types of each are equally 
defensible. It is easier to maintain the legitimacy of some than 
that of others. It would be easier to make a case for giving these 
incomes to the state in some cases than in others. In contrast with 
the more extreme claims for the present order which are sometimes 
made, what we here contend for is merely this : The present as- 
signnent of the incomes in question is not inherently unreasonable 
or unjust: the not uncommon contention of even moderate advocates 
of reform that the private appropriation of any income not derived 
directly from personal exertion is something very like robbery, thor- 
oughly wrong under any condition, — this contention is entirely un- 
sound. 



532 PRINCIPLES OF ECONOMICS [XLV 

It may perhaps seem that a defense of the present order which 
contends for no more than the proposition just laid down, would 
scarcely be worth while. If it be admitted that the state can with- 
out injustice take from private persons the right to receive the 
incomes in question, we may be quite sure, the objector might say, 
that would-be reformers would in time persuade themselves that 
there is ample reason for adopting such a policy. Personally, I 
am not in accord with this view. It has always seemed to me that 
the strength of the socialist movement largely consists in the ac- 
ceptance of a grossly unfair indictment of the present order. Men 
honestly believe that, from the very nature of present arrangements, 
the capitalist, however honest or benevolent, cannot help exploiting, 
or robbing, labor. The acceptance of such a doctrine makes the 
masses "see red." Convince them that it is an erroneous doctrine, 
and you will have done much toward eliminating their desire for 
a new regime. In any case, you will have diminished the intensity 
of the emotional forces working for the movement, and will have 
thereby contributed toward a more temperate and reasonable altera- 
tion of the existing order, if altered it must be. 

I 

Criteria for Passing Judgment on the Legitimacy of a Particular 
Assignment of the Property Incomes 

In passing judgment on the legitimacy or reasonableness of any 
social institution or policy, it is obviously necessary to have in mind 
some standards or criteria of such legitimacy. Doubtless there is 
room for difference of opinion as to the true criteria for the case 
before us ; but I shall assume with little argument that the follow- 
ing propositions are fairly adequate. 

(i) In determining the proper destination of so much of the 
value income as expresses the contribution of a given factor, there 
is a presumption in favor of the person responsible for the exist- 
ence of such factor, when such person exists. 

(2) When no. person is responsible for the existence of a given 
factor, for example, in the case of the factors commonly covered 
by the designation, land, the presumption is in favor of men gener- 
ally, or the community as a whole. 



XLV] INCOMES OF PRIVATE OWNERS 



533 



(3) The valid claim of any person can be completely alienated 
by that person and completely acquired by another person through 
an act of exchange, sale and purchase, — it being assumed that said 
exchange was on equitable terms approved by the state. Thus, if 
a person catches a hundred fish, his claim to property in those fish 
because he caught them ceases to have any validity after he has 
sold them. 

(4) The state, as the guardian of the welfare of all and hold- 
ing in trust the residual claims of all which grow out of the contri- 
butions to production derived from factors not appropriable or not 
appropriated, for example, the fund of accumulated knowledge, the 
protection of government, etc., has the power and right to confirm, 
limit, or cancel all presumptive claims as may seem wise, and the 
power to alienate its own claims. Thus, if it seems on the whole 
best, the state can without injustice abolish the right of private 
persons to receive the interest income, even though it be admitted 
that such destination of interest has presumption on its side. On 
the other hand, granting that the state, as representing men in 
general, has the best presumptive claim to the rent income, still 
the state can, without wrong, alienate that income to private per- 
sons, if there seem to be adequate grounds in expediency for such 
procedure. 

Defense of These Criteria. — Since the acceptance of these 
propositions would render needless any prolonged consideration 
of the reasonableness of the individual incomes, we must take a 
moment to comment upon them. The first would probably lead to 
little controversy, being a widely accepted doctrine of very an- 
cient origin, and one favored by the opponents of the present or- 
der, as well as its supporters. As to its general validity, there 
would seem to be no serious reason for doubt. To have been 
responsible for producing a thing, if it does not create an absolute 
claim to the services or contributions of that thing, must certainly 
create a presumptive claim of this character. 

The second proposition would seem equally certain. Doubtless 
man's need is, in some sense, the most ultimate ground of the right 
of property in things. But this ground is common to all men 



534 PRINCIPLES OF ECONOMICS [XLV 

placed in the same situation; and, in the absence of any presump- 
tion in favor of special persons, the state, as representing all, could 
surely set up the best claim. 

The third proposition is too evident to need argument. To 
have produced a thing could not continue to be a valid ground for 
claiming property in that thing after tt had been relinquished in 
legitimate exchange. Controversy might always arise as to whether 
the price paid in the exchange had been a fair one; but this is a 
matter for regulation by itself. It ought not to be confused with 
the question of title to the thing sold. 

The fourth proposition would not receive so ready assent as the 
third. In fact, it would doubtless meet opposition from both con- 
servatives and radicals. The former would deny that the state can 
legitimately limit certain fundamental property rights at all, for 
example, the right of capitalists to control entirely the disposal of 
their capital. Radicals, on the other hand, would deny that the state 
could ever legitimately alienate its property rights in land and 
natural resources. Nevertheless, the proposition, as originally laid 
down, seems a necessary foundation for any adequate social order. 
It must always be the right and duty of the state tO' establish and 
maintain such social and economic arrangements as seem necessary 
to secure the best results for society as a whole. If, then, the state 
becomes convinced that, however natural and reasonable it may 
be to permit private property in capital and the private appropria- 
tion of the income thereof, yet, everything taken into account, such 
a system works much more evil than good, the state must surely 
be bound to abolish that system, in spite of the presumptions in its 
favor.^ On the other hand, if the state becomes convinced that 
the best good of all demands the alienation of its claims on natural 
resources to private persons, such action is surely within its sov- 
ereign prerogatives and duties. 



* The right of private persons to use any wealth to which they have 
a valid claim, in initiating and guiding industrial activities, is surely no more 
reasonable on its face than the right of the same persons to use that wealth 
in buying such consumption goods as they may desire. Yet practically no 
publicist of standing would deny that it is within the prerogatives of the 
state to limit the latter right, and, in some cases, to abolish it altogether. 



XLV] INCOMES OF PRIVATE OWNERS 535 



II 

The Legitimacy of a System Which Permits the Capital 
Incomes to Be Appropriated by Private Persons 

In view of the preceding discussions, little more seems needed 
to establish the proposition that there is nothing inherently un- 
reasonable in the present destination of the capital incomes, that is, 
their being appropriated by private persons ; that, on the contrary, 
such destination has in its favor a most evident presumption. Cap- 
ital as capital — the power to wait and to assume the responsibility 
of production — is a product and one for the existence of which 
private persons are commonly responsible. In order that it should 
come into existence, someone must produce an income and, through 
saving from that income, accumulate a surplus. Nor is this rea- 
soning invalidated by the consideration that the particular person 
now enjoying its incomes obtained that capital through fraud or 
violence or inheritance. Such considerations are beside the issue. 
We are here concerned only with the reasonableness of the capital 
incomes per se. In affirming that the private destination of these 
incomes has a presumption in its favor, because the person receiv- 
ing those incomes produced the capital from which they spring, 
we are not called on to defend such a destination of profit and in- 
terest, when admittedly this reason was not present. Of course, no 
one contends that a man who has obtained capital through fraud 
or violence ought to be permitted the enjoyment of its incomes. As 
to whether there can be any legitimate bequest or inheritance, opin- 
ion is not unanimous. But, in any case, the matter does not con- 
cern us. In the typical case, the capitalist is responsible for the 
existence of the capital ; and the presumption is that, because of 
that fact, he has a right to its fruits. 

The Laborer's Claim. — But the opponents of private profit 
and interest would not be content without setting up some other 
claimant over against the capitalist himself. A fairly complete 
enumeration of possibilities would perhaps give us three, as fol- 
lows: (l) the laborer who works with, utilizes, the capital in 



536 PRINCIPLES OF ECONOMICS [XLV 

question, (2) the consumer of the particular commodities in the 
production of which the capital in question is utilized, and (3) the 
citizen or member of society in general. The first of these, as 
everyone knows, is the favorite claimant. The basis of his claim 
is the doctrine that laborers only contribute to the production of 
commodities. I trust we may safely assume that this doctrine has 
been completely disposed of in preceding discussions. Capital as 
capital, not merely capital as the embodiment of previous labor and 
other factors, is a real factor in production, makes a contribution 
of its own to the total result ; and the importance of this contribution 
is more or less fully expressed in the price paid therefor. The 
laborers who have been engaged in utilizing said capital did not 
make the contribution in question, and have no more claim on the 
incomes expressing the importance of that contribution than have 
any other members of the community. 

The Consumer's Claim. — The case against the second claim- 
ant, the consumer of the particular commodity in the production 
of which the capital was utilized is equally plain. As was ex- 
plained on page 527, such destination of the capital incomes could 
be brought about by omitting these elements from our cost calcu- 
lations when deciding what price should be charged for any given 
product. 

But against such a policy two strong objections would present 
themselves. First, there is nothing whatever in the status of the 
consumer as such on which to base a claim to these shares. On 
the contrary, the very nature of his position naturally calls on 
him to pay rather than receive. He enjoys the utilities derivable 
from the product; he should fully make good its costs. In the 
second place, distributing the incomes in question to consumers by 
omitting profit and interest from prices would necessarily involve 
a wholly baseless discrimination among consumers. For waiting 
and risk enter into the production of different commodities in quite 
different proportions, and these commodities enter into the con- 
sumption of different citizens in quite different proportions; hence, 
some persons would be large consumers of products costing much 
waiting and risk, and so would gain much from the generosity of 



XLV] INCOMES OF PRIVATE OWNERS 537 

the state, while others would consume but little of such commodi- 
ties, and so would be small gainers from this policy. 

The Citizen's Claim.^There, then, remains only the third 
possible rival to the capitalist as the legitimate claimant of interest 
and profit, that is, the citizen in general. As against the claims of 
either of the other two rival claimants, this one of the citizen in 
general is surely the best. The claims of the laborer and consumer 
have no foundation; for that of the citizen in general, some very 
slight basis may be discovered. The citizen in general is the 
residuary legatee of all rights, advantages, for which a truly legiti- 
mate claimant cannot be found ; for he stands for humanity in 
general, is the inheritor of the knowledge and skill brought down 
from the past, and the maintainer of the political and legal institu- 
tions essential to all economic life. Nevertheless, it is surely little 
short of absurd to argue that the claim to the capital incomes set 
up by the mere citizen who has had no share in producing that 
capital is as good as that of those persons who are just as much 
citizens as himself and, in addition, have really produced the capital. 
Surely the claims of the latter have a strong presumption in their 
favor, though, as so often admitted, they may be overridden by 
weighty considerations of public advantage. 

Illustrative Problem 

The medieval church attempted to eliminate completely the taking of 
interest, but thought it right for capitalists to gain a profit from the con- 
duct of business enterprises. Can you see any reason why the case for 
profit would seem to be better than that for interest? 

Ill 

The Legitimacy of Rent as a Private Income 

It is manifest that the right to receive rent, the income which 
represents the marginal importance of the contribution made by 
the land, cannot be defended on the ground brought forward in the 
case of the capitalistic incomes,— the ground, namely, that the 
receivers of the income in question are responsible for the existence 



538 PRINCIPLES OF ECONOMICS [XLV 

of the source from which that income springs; for, broadly speak- 
ing, land is not producible. Again, this fact that land is not pro- 
ducible means that the presumptive title to this factor belongs to 
the community, the state. It- follows that private persons can ob- 
tain a valid title, if at all, only through the grant of the state. The 
real question, therefore, is this : Can the state legitimately alienate 
its title to the land, or, anyhow, its title to the income of the land? 
An affirmative answer to this question seems inevitable. 

Alienation and Social Expediency. — First, it is scarcely to 
be doubted that the state could make such renunciation of its rights 
on non-economic grounds, grounds of political or social expediency. 
Thus, it may be argued that an almost indispensable means for 
insuring stability in the social order is the presence of a consider- 
able class rendered peculiarly interested in the maintenance of 
such stability, and peculiarly likely to develop the habits and dis- 
positions which render it well fitted to maintain that stability; and 
that one of the best methods of developing such a class is to es- 
tablish a system of private property in lands used for farming 
purposes. Such an opinion has long been held and has long in- 
fluenced powerfully the action of governments. Whether sound 
or not, this opinion would seem to justify the corresponding action 
on the part of the state ; for the state has no choice except to act in 
accord with its best judgment in trying to secure the best good 
of all. 

Illustrative Problem 

The policy pursued by the leaders who reorganized society after the 
dissolution of Roman political civilization of making huge grants of land 
to their chief subordinates doubtless contained the seeds of many abuses. 
Nevertheless, much is to be said in favor of the legitimacy, almost the 
necessity, of instituting such a policy. Defend the latter statement. 

Alienation and Economic Services. — But, again, it seems 
plain that the state could legitimately renounce its natural right to 
the land and its income, in return for economic advantages or 
services which, in the opinion of the pubHc, were worth the price. 



XLV] INCOMES OF PRIVATE OWNERS 



539 



One of the most familiar and universal cases of this kind is fur- 
nished by the practice prevalent in all ages of granting a more or 
less complete property right in land to persons who opened up, 
cleared, or otherwise brought into a productive state lands hitherto 
unused. Scarcely distinguishable from this case is one which arises 
when governments make grants of lands in order to develop the 
country as a whole, swell its population, expand the market for the 
manufacturing and commercial industries of the older parts of the 
country, and so on.. 

Alienation and Efficiency. — Another case of alienating the 
nation's property in the land in exchange for supposed economic 
advantages appears when land is granted to private persons in or- 
der to secure the highest efficiency in its utilisation. This has played 
no inconsiderable part in initiating and maintaining the right of 
private property in this fundamental factor of production. Ex- 
perience is believed to have shown that, in farming, ownership will 
yield far better results than any sort of tenancy. In this connection, 
it is interesting to note that advocates of socialism have in later 
years felt almost obliged to hint at excepting agriculture from their 
system of universal undertaking by the government.^ This notion 
that the private control of the land, on the whole, works for su- 
perior efficiency, has been brought forward even in the case of 
lands used as sites for the manufacturing and commercial industries. 
Not a few advocates of a single tax on land have given up the plan 
of making this tax cover the whole rent, on the ground that this 
policy would lead owners to relinquish their rights to the public, a 
result which would substitute expensive and inefficient public man- 
agement of these sites for a private one which is fairly free from 
these defects. 

Alienation and Capital Burdens. — A final, and even more 
strictly economic, advantage of turning the land of the community 
over to private ownership is found in the fact that thereby the public 



"It was reported this winter (1921) that the communistic government of 
Russia had decided to release the peasantry in large measure from the 
operation of their system. 



540 PRINCIPLES OF ECONOMICS [XLV 

escapes various burdens incident to occupying the position of land- 
owner. It has already been fully explained that the price-making 
forces give to a non-producible income-bearer such as land a price 
ecjual to the capitalisation of its income. It follows that every per- 
son owning a piece of income-bearing land must consciously keep 
invested in that land a sum of general value equal to the amount 
which at current rates of interest would yield an income equal to 
the one given off by said land. In doing this, he necessarily makes 
two sacrifices: (i) foregoing the present control and use of the 
amount invested, and (2) taking the risk that, through the decline 
in the income of said land, he will suffer more or less loss on the 
capital sum. In the language of the business world, the land has to 
be "carried." Now the bearing of these two burdens of ownership 
would doubtless be less onerous to the socialist state than it is at 
present to private owners. But it could not help being present, par- 
ticularly the first of these. Circumstances might easily arise under 
which it would be greatly to the advantage of the state, or anyhow 
would be so considered, to exchange the right to receive an endless 
series of small future incomes for the right to have now a lump 
sum equal to, say, twenty times one of those small incomes. That, 
under such circumstances, the state would be justified in relinquish- 
ing to private persons the right which naturally belongs to it as the 
representative of men generally seems incontestable. Such a con- 
clusion follows inevitably from any doctrine of sovereignty: the 
state has the right to do, ought to do, whatever it believes to be on 
the whole most conducive to the general good. 

Considerations of Equity. — As a final comment of some 
weight in the situation, we may call attention to a fact implicit in 
what was just said with respect to the capitalization of the income 
of the land. This process means that the rent is in effect trans- 
formed into interest and profit, — quasi-interest and quasi-profit. 
When a system of private property in land has been maintained for 
any considerable time, persons can put themselves into the position of 
rent-receivers only by parting with an amount of money capita^ 
equal to the value of the property in question. It follows that, 
from the standpoint of abstract justice, if only these persons are 



XLV] INCOMES OF PRIVATE OWNERS 



541 



taken into account, the rent received is as truly justified as interest 
and profit received from any ordinary capital. The public interest 
may sometimes require a complete disregard of the claims thus 
created. But this is true of all rights. Until such a situation 
arises, the presumption holds that what the citizen has obtained 
through exchange for an equivalent sum of general v^ealth he has 
a valid right to enjoy. 

IV 
Further Modifying Conditions of Actual Life 

In the preceding defense of the existing system of distribution, 
we began by arguing for the general reasonableness of the principle 
which is supposed to be realized more or less fully in that system, — 
that is, the principle that each tends to get an income correspond- 
ing to the social value of his services — his contribution to our eco- 
nomic life. We next undertook to maintain the thesis that said 
principle is still reasonable even under the specific conditions which 
enter into the actual economic order. In doing this, however, we 
have merely taken into account one set of conditions, namely, that 
legal system which permits private property in land and capital 
and so recognizes the contribution of these factors as being virtu- 
ally contributions of private persons, and which, therefore, recog- 
nizes rent, interest, and profits as legitimate sources of private 
income. 

If we were trying to make a truly complete critique of the ex- 
isting system of distribution, we should be compelled to test the 
legitimacy of our service-value principle in the presence of many 
other modifying conditions. To carry out this test, however, would, 
take us far beyond the scope of the present volume. We shall 
therefore content ourselves with mentioning some of these condi- 
tions, without attempting more than the briefest comment. 

Defects of Human Nature. — In the present chapter w^e have 
merely attempted to argue for the general, abstract legitimacy of 
interest, profits, and rent as private shares, having no regard to the 
weaknesses of human nature. Taking those well known weak- 



542 PRINCIPLES OF ECONOMICS [XLV 

nesses into account, can the shares named still legitimately go to 
private persons ? We recognize this question as a really serious one. 
We see much force in the contention that, however reasonable it 
may be on general principles to permit the private ownership of 
capital and land and the private undertaking of industry, the evils 
which inevitably results from such a policy in the actual working of 
things make its continuance impossible of justification. Still, in 
view of the great superiority, in other respects, of private, to public, 
ownership, and in view of the fact that its worst evils can be 
gradually removed without overturning the system, we believe that 
the system of private ownership should be maintained. At the 
same time, however, regulation of private initiative should un- 
doubtedly be carried much further than it has been, limitations of 
the property right should be increased, and at some points, how 
many and what only experience will show, public ownership and 
initiative should he substituted for private. 

Rights of Inheritance and Bequest. — A second supplemental 
question of much importance is whether the present system is justi- 
fied in permitting private individuals to acquire possessions through 
inheritance or bequest. Personally, I am disposed to answer this 
question in the affirmative but only with very emphatic qualifica- 
tions. I would greatly reduce these rights both directly by legisla- 
tion and indirectly by a taxation which, for the excess of larger 
estates over a certain minimum, would amount to practical con- 
fiscation. 

Social Opportunities. — Still another question is whether law 
should permit private persons to enjoy the extraordinary profits 
which flow from the exploitation of natural resources, public fran- 
chises, consolidations, etc. We can only say in this limited space 
that such permission is of very doubtful justice, and should at least 
be carefully guarded. 

Secondary Distribution. — Finally, how far can society afford 
to modify the primary distribution of property and income through 
a secondary distribution effected by taxation? It would seem 



XLV] INCOMES OF PRIVATE OWNERS 543 

that, if the dominance of the present principle of distribution — to 
each in accord with the value of his service — is necessary to insure 
the proper conduct of economic affairs, we should spoil everything 
by arbitrarily contravening the working of that principle, even 
though we do this after distribution in accord with the principle 
has once been effected. For what interest would a man have in 
earning ten times as much as his fellows, if he is to be reduced to 
their level by taxation ? Doubtless, if it were to go so far as this, he 
would have no interest in seeking the better income. But, on the 
other hand, there can be no doubt that a tax much heavier than 
that levied on his poorer neighbor would not influence in any 
material degree his economic efficiency. The whole problem is one 
of degrees. Its solution probably can be reached only through ex- 
periment, and for that we shall have to wait. 

Illustrative Problem 

The chief justification for the retention of a system which permits 
private ownership in property and private receipt of property incomes is 
based, in the last analysis, on the ground of expediency. Such a system 
works fairly well. Practically, the individuals in whom are vested the 
legal titles to property and to the incomes derived from them, act as 
stewards for society in the care and utilization of these properties, and 
in the disposition of a large part of the incomes derived from them. 
Argue in support of the thesis contained in the second sentence. 



CHAPTER XLVI 

CRITIQUE OF THE PROCESS WHEREBY PRODUC- 
TION IS REGULATED 

The chief characteristics which we can reasonably require in 
a productive system are : ( i ) that the right things shall be pro- 
duced; (2) that the quantity of product shall be reasonably large; 

(3) that the quality of product shall be reasonably good; and 

(4) that these results shall be realized as continuously as pos- 
sible, — in other words, that production as a whole shall be as free 
as possible from marked irregularities. In the present chapter we 
take up the first of these requirements, — that the right thing shall 
be produced, or The Regulation of Production. 

It has by this time become a commonplace that, under the pres- 
ent order, the selection of what shall be produced is almost entirely 
effected through freely-determined prices. Now, as the earlier 
economists taught, if the present system could realize fully the con- 
ditions which are assumed as fundamental to it, this regulative 
mechanism would probably be an almost perfect one. The spon- 
taneous working of free competition would result in prices which 
would insure production of the things called for by the general 
advantage, — the things which a wise dictator dealing with the same 
conditions would think it expedient to produce. Further, the 
earlier economists commonly believed that, even under the condi- 
tions actually existing, price-gu'ided production in the main worked 
out results as near the ideal as could reasonably be expected. 

In our day, this opinion is probably still held by the majority of 
economists. But a not inconsiderable minority take radical ground 
on the other side. A few even insist in unqualified terms that there 
is no truth whatever in the older doctrine, that there is not even a 
tendency for production to follow the channels which social or 
general advantage would dictate. In view of this disagreement, a 

544 



XLVI] CRITIQUE OF PRODUCTION REGULATION 545 

careful and rather full treatment of the matter seems called for. 
We ask, then : Do the principles governing price promise to secure 
a reasonable guidance of productive activity f In answering this 
question, we will first comment briefly on the standard to be set up 
in judging whether a particular guidance of production is reason- 
able; after which we will pass in review the leading principles of 
price, and try to determine the fitness of each to meet this test. 



What Is a Reasonable Regulation of Production? 

The answer to this question has already been made in introduc- 
ing our critique of Distribution in Chapter XLII. The general ob- 
ject of an economic order of any kind is to secure the satisfaction of 
human wants in so far as this depends on economic goods. Just 
what wants shall be included under this general category, and the 
comparative order of their importance as between different persons, 
are determined by the system of distribution. It follows that 
production, like all other economic processes, should be so regulated 
as to correspond to the system of distribution, — to provide for the 
satisfaction of "wants according to the scale which is in effect em- 
bodied in the system of distribution. This means that, broadly 
speaking, no wants are recognized as social wants except those of 
persons having incomes under the existing system of distribution, 
and that the wants of different persons have a social importance 
corresponding to the size of their incomes. Finally, it means that 
the general demand schedules made up of the different individual 
demand schedules, composite as they are, express the social im- 
portances of wants. 

Objections: Absolute Magnitude. — The objection to this 
method of rating wants, that it does not rate them according to 
their real or absolute magnitude, has been answered directly or 
by implication in the argument for the general reasonableness of the 
present system. The social magnitude of wants is the only one in 
which society at large is interested; and the social magnitude of 
wants is by no means identical with their absolute magnitude. In 



546 PRINCIPLES OF ECONOMICS [XL VI 

the spring of 1918, the wants of a French private soldier may have 
had as great absolute magnitude as those of Marshal Foch; but, 
quite obviously, they had much less social magnitude. 

Circular Reasoning. — Another and somevi^hat more serious 
objection to the doctrine before us is that, taken as a whole, it in- 
volves circular reasoning. "On the one hand, letting ordinary de- 
mand prices — mere composites of heterogeneous individual schedules 
— represent the social importance of wants is said to be legitimate, 
because this is the necessary complement of the system of distribu- 
tion. On the other hand, the system of distribution is said to be 
legitimate, because it gives each person what his services are worth 
as indicated by the general demand schedule. The system of dis- 
tribution establishes the legitimacy of the demand schedules; the 
demand schedules establish the legitimacy of the system of dis- 
tribution." 

Now, this sounds plausible; but it will not, after all, bear exami- 
nation. It would be true only on condition that all large incomes 
were obtained by catering to the demand of persons of large incomes 
only. We should then be defending the power of a particular group 
of persons to influence unduly the course of production, on the 
ground that this was the necessary complement of a system of dis- 
tribution which gave persons of that group large incomes because 
those persons supplied services which were accounted very impor- 
tant, because persons of that same group, having large incomes, were 
able to rate those services highly. But I hardly need say that no 
such relation exists between large incomes and their source. The 
great majority of persons in receipt of large incomes get those in- 
comes from industries which cater, not to the demands of large- 
income persons only, but rather to the demands of all classes. The 
circularity complained of is not, therefore, characteristic of the ac- 
cepted reasoning, but only of special cases to which that reasoning 
may be applied. 

Recapitulation. — In order to emphasize the entire course of 
reasoning on this matter, let us recapitulate it in a series of proposi- 
tions as follows : 



XLVI] CRITIQUE OF PRODUCTION REGULATION 547 

(i) The kind of importance in respect to wants with which 
society is really concerned and which, in the interest of the social 
welfare, should be treated as the proper guide of economic action 
is social importance. If this is not identical with individual or abso- 
lute importance, the latter must yield. 

(2) The social importance of the wants of different individuals 
depends, not primarily on the absolute magnitude of those wants, 
but on the relative importance of the different social ends the attain- 
ment of which may be conditioned on the satisfying of those wants, 
and the degree to which their attainment is so conditioned.^ 

(3) One important way in which the attainment of social ends 
is conditioned on the satisfying of individual wants is found in the 
fact that the getting of efficient service from individuals is dependent 
on providing for the satisfaction of their wants in certain propor- 
tions. If we do not provide for their wants in these proportions, 
we do not get the service called for. 

(4) On account of the great inequalities in human capacity and 
the consequent inequalities in the importance of the services different 
men can render, it is practically indispensable that this satisfying 
of their wants on which their efficient service is conditioned, should 
have some reference to the importance of those services, and so this 
satisfying of wants should he unequal as between different persons. 

(5) Under the present system, society elects to attain the end 
by making the money incoines of different individuals unequal and 
roughly adjusted to the importance of their services, — leaving those 
individuals themselves to put a rating on the relative importance of 
wants. 

(6) In doing this, society necessarily recognizes these indi- 
vidual ratings of the importance of wants as social ratings, express- 
ing the true, though indirect, social importance of those wants. 

(7) It thus follows that, broadly speaking, the demand prices 
of the ordinary demand schedules are, in a very real sense, expres- 
sions of the social importance of the wants involved. 

Qualifications. — Having so roundly emphasized the point that 
the demand schedules resulting under the existing system of distri- 
^ See Note 10, Appendix. 



548 PRINCIPLES OF ECONOMICS [XLVI 

biition represent broadly comparative social wants, let me once mcrre 
remind the reader that this must be qualified if it is to be an entirely 
true account of the matter. At several points, other indices of the 
true social importance of wants are needed. The state must find 
other criteria when the wants of the group as a whole come into 
conflict with those of individuals ; when the needs of future genera- 
tions conflict with those of the present ; and when the most funda- 
mental needs of many individuals are opposed to the trifling needs 
of the few. In short, the general position here taken, that we must 
accept the demand prices of individuals as indices of social impor- 
tance is in general perfectly sound; but, as in other cases, it is not 
always valid : these indices must at times give place to others better 
adapted for the particular case in hand. 

Illustrative Problem 

It may be socially more important that a great executive enjov a 
week's outing on which he is willing to spend $i,ooo, than that a common 
laborer get a winter's supply of coal on which he can afford to spend, 
say, $150. Defend that statement. 

II 

Are Prices Which Are Determined Under the Law of Single 
Price Proper Guides of Production? 

Having now so definite a criterion as to what constitutes a proper 
regulation of production, our review of the different laws of price 
which participate in this process ought to prove a relatively easy 
task. First, then, we ask: Is the law of single price a suitable 
element in the mechanism which has the function of regulating' 
economic production? The answer is surely an af^rmative one. 
First, it is manifest on a little reflection that singleness of price is 
necessary to the realisation of the system of distribution authorized 
by society. If incomes were equal, while the same goods had dif- 
ferent prices, the equality of incomes would be defeated by indirec- 
tion. One man could not get as much real income as another man 
though their money incomes were equal. On the other hand, if 
society decrees inequality of income, singleness of price is necessary 



XLVI] CRITIQUE OF PRODUCTION REGULATION 549 

both from the standpoint of the man of small income and from that 
of the man of large income. If prices were lower to the rich man 
this would increase the inequality, make it greater than the social 
intention. If prices were higher to the rich man this would neu- 
tralize the superiority of his income. 

But there is another reason and if anything a more fundamental 
one why the law of single price is a proper element in the system 
guiding production. It is logically essential to having price act as a 
guide at all. Guidance, like sovereignty, must be indivisible. One 
price for each product or each factor can guide us in the production 
of that product or the use of that factor; but many prices for each 
could not guide at all. Thus, if the relation of supply and demand 
is such that common sand is at the margin worth 50 cents while 
moulding sand is worth $1, these prices can perform their function 
in showing us that common sand can properly be put to uses as low 
as 50 cents while moulding sand must be reserved for uses rated as 
high as $1, only on condition that the one price of common sand is 
50 cents and the one price of moulding sand is $1. If at the same 
time common sand has prices of 50 cents, 75 cents, $1, $1.25, $1.50, 
and so on, we should have no guidance whatever from this source, — 
prices would have no significance as respects the importance of the 
things involved. 

Ill 

Are Prices Which Are Influenced by Demand Prices and the 
Forces Behind Them Proper Guides of Production? 

We have seen that the law of single price constitutes not only a 
legitimate, but also a necessary, element in an economic order which 
entrusts the regulation of production to freely determined prices. 
What now is to be said of those principles which impute to demand 
prices and the forces behind them, significance, utility, a share in the 
fixing of actual prices, and therefore in the regulation of produc- 
tion f Do these constitute a legitimate element in the regulative 
mechanism? Is it reasonable that actual prices which approximately 
equal demand prices, and approximately express marginal utilities 
or significances should participate in the guidance of production? 



550 PRINCIPLES OF ECONOMICS [XLVI 

The Case of the Individual. — In giving an affirmative ansvv^er, 
the majority of economists have probably had in mind the analogy 
of the individual guiding his own economic life in accord with his 
individual demand schedules. With respect to the reasonableness of 
his conduct in doing this, there has been no serious difference of 
opinion. Those schedules consist of money expressions of utility or 
significance for different commodities. These money expressions 
are fairly accurate indices of the comparative importance to the indi- 
vidual of the utilities in question, and so of the goods which yield 
the utilities. And the function of such money expressions of utilities 
or significances is to guide the individual in the rational utilization of 
his income or resources from which to secure an income. Speaking 
broadly, each person should, as far as possible, employ his income 
of purchasing power in such a way that the marginal utilities derived 
from equal portions of that income would be equal; and, when this 
is not possible, shoidd employ said income in such a way that utilities 
or significances of higher rank would never be sacrificed for utilities 
or signiiicances of lower rank. The practical wisdom of such a rule 
of conduct is plain, for it surely is the part of good sense to provide 
for the satisfaction of our wants in proportion to their importance. 

The Case of Society. — Is there a true analogy between this 
case of the individual and that of society as a whole ? Is there a rule 
analogous to that just laid down for the individual which can rea- 
sonably be applied to society as a whole ? Is it reasonable that we 
should, generally speaking, so use our resources that marginal 
utilities, as these appear to be when judged by the general demand 
schedules, shall be substantially equal all along the line ? That such 
a rule for society at large actually obtains is evident enough. That 
is, society's use of its income or income-bearing resources is in fact 
guided by the market demand schedules which were studied in 
earlier chapters. Through the guidance of these schedules, re- 
sources are so employed that the marginal want satisfied in any one 
of many different lines is equal, — when measured by the persons 
interested, in a unit which is at least nominally the same, — to the 
marginal want satisfied in any other of those different lines. In 
other words, if we recognize demand prices as a true index of the 



XLVI] CRITIQUE OF PRODUCTION REGULATION 551 

size of wants, then i dollar's worth of resources are used to satisfy 
what seem to be $1 wants, not 50-cent wants nor $2 wants. But, 
while such a rule does obtain for society in general, the question 
remains whether this rule can be interpreted and justified as the 
analogous rule is in the case of the individual. Are these demand 
prices of the general demand schedules a true index of the real 
social magnitude of wants ? Do they express comparative social or 
general importances in anything like the same way that the demand 
prices of the individual schedule express comparative individual im- 
portances? If they do, — and only if they do — we may say that the 
guidance of production effected through them in a rough way 
secures the gratification of wants in proportion to their importance, 
and is, therefore, a reasonable one. 

Affirmative Answer. — This question has already been an- 
swered in the affirmative on pages 507-510. Given a system of dis- 
tribution approved by society (and a system of distribution cannot 
exist without this approval), the general demand schedules are social 
schedules, schedules representing social significances or importances, 
as these are determined by the vast comp'lex of conditions which at 
any moment prevails. To this broad statement, there are several 
qualifications, as already brought out ; but the statement is, after 
all, substantially true. The objection, that, on account of the differ- 
ent meanings of the money measure to different persons, the prices 
of the general demand schedule do not represent the absolute mag- 
nitude of wants, has already been sufficiently answered. The rea- 
sonable, the proper, guide to the use of the resources belonging to a 
social group is not the absolute magnitude of wants but their social 
magnitude. Production should be so guided as to secure the greatest 
social, not individual, advantage. We are not, therefore, concerned 
with absolute magnitudes. 

If the objection is to be interpreted as really directed against the 
use of the term "utility" and the phrase "marginal utility" in this 
connection, the matter, like other verbal controversies, is not of 
great moment. The general point, however, is important. In ac- 
cepting the guidance of ordinary demand schedules in the use of its 
resources, society, broadly speaking, insures that those resources 



552 PRINCIPLES OF ECONOMICS [XLVI 

shall he used in a "may which provides for the satisfying of wants in 
proportion to their social significance. 

IV 
Are Prices Which Follow Cost Proper Guides of Production? 

Among the most important of the principles through which prices 
are determined are those which affirm some kind or degree of causal 
connection between price and cost of production. Broadly speaking, 
in most cases prices have tO' equal marginal cost of production; or, 
anyhow, the prices of different goods have to show the same ratios 
as their costs of production. A commodity costing twice as much 
as some other commodity must have a price approximately twice as 
high. Is such a principle as this a suitable element in the mechanism 
which regulates production? Does it tend to insure that our re- 
sources shall be most wisely utilized? 

Here, again, the answer is certainly an affirmative one. Prices 
which have the regulating of production, which are called on to 
utilize our resources to the best advantage, can do this only on con- 
dition that they are, generally speaking, coincident with marginal 
cost. Correct prices, prices fatted tO' guide production rightly, must 
be adjusted, not only to demand prices and the forces behind them, 
but also to supply prices. If the price of any particular commodity, 
as compared with those of other commodities, was higher than its 
cost, this could be only because that price was being held up by a 
marginal significance or utility abnormally high as compared with 
that of other commodities having the same cost. But, since it is our 
business so to use our productive resources that a given unit of those 
resources yields equal or almost equal marginal utilities all along the 
line, the abnormally high marginal utility of our special commodity 
would mean that too little of our resources was being used in the 
production of that commodity, too much in the production of other 
commodities. On the other hand, if the price of any particular 
commodity, as compared with those of other commodities, was 
below its cost of production, this could be only because that price 
was being held down by a marginal significance or utility which was 
abnormally low as compared with that of other commodities having 



XLVI] CRITIQUE OF PRODUCTION REGULATION 553 

the same cost. But, in view of our rule of equal marginal utilities, 
this abnormally low marginal utility of our special commodity would 
mean that too much of our resources was being used in its produc- 
tion, too little in the production of other commodities. 

Illustrative Problem 

"Our attitude on the matter of pay to teachers is simply absurd. We 
pay less for this function which has such supreme importance to society 
than to the least skilled mechanic working in an automobile factory. But 
we shall be brought to our senses one of these days by learning that we 
simply will not be able to get teachers at the beggarly wages we pay." 

Of these two reasons for paying higher wages to teachers, the former 
is from the standpoint of economic science a worthless one ; the latter a 
good one. Defend that statement. 



CHAPTER XLVII 

CRITIQUE OF PRODUCTION IN RESPECT TO 
EFFICIENCY 

In beginning the last chapter we said that a satisfactory economic 
order might reasonably be expected to produce the right things, to 
produce them in large quantity, to produce them of excellent quality, 
and to produce them without marked irregularities. We have thus 
far seen that the existing order, governed as it is by the laws of 
price, meets the first of these conditions — the production of the 
right things — reasonably well. It is the task of the present chapter 
to make a similar, though briefer, test of the three remaining 
conditions. 

I 

The Present Order and a Large Volume of Products 

To the question whether the present order is fitted to make the 
volume of products large, almost all students of our subject give a 
favorable answer. In general, abundance of products must depend 
chiefly on three conditions : (i) a large volume of productive factors, 
(2) high efficiency in those factors, and (3) most profitable utilizing 
of those factors. Let us consider these in order. 

Volume of Capital. — As respects the volume of resources, no 
system can alter this as far as it depends upon nature. But the fac- 
tors dependent on human choice — all forms of labor, waiting, and 
initiative or responsibility-taking — may be supplied in small or in 
large volume according to conditions. As regards the second and 
third, the present order promises to do much better than any substi- 
tute ever seriously considered. A large volume of capital, which 
is the sole condition for an abundant supply of waiting power and 
the principal one for an abundant supply of initiative, is surely 

554 



XLVII] CRITIQUE OF PRODUCTION EFFICIENCY 555 

more likely to be realized under the present order than under social- 
ism. With the present order, the accumulation of capital is left to 
private initiative, and a reward offered, in the shape of interest and 
profits, makes possible the attaining of a competency with its free- 
dom from labor. Under socialism, private capital, anyhow private 
interest and profits, would be eliminated. Society would, therefore, 
have to depend on something akin to taxation as a means for accu- 
mulating capital. But in a democratic state, with inequalities of 
income eliminated or much reduced, it is hard to believe that capital 
could be largely accumulated by such a method. 

Volume of Labor Services. — Turning to the labor factor, v^e 
must admit that a socialistic order would show less difference ; but it 
would after all give smaller resources than the present order. One 
of the leading aims of socialism is to diminish individual responsi- 
bility in economic things. It does not, indeed, plan to go as far as 
communism, treating all members of the community as if they were 
members of one common family, — insuring them a livelihood any- 
how. But it does propose to go a long way in this direction, — to 
insure everyone a job and a so-called living wage, — to relieve every- 
one of much of the anxiety which characterizes the present order. 
Now, this may be on the whole very desirable ; but it can scarcely 
fail to reduce the energy, industry, alertness, and prudence which 
men bring to their tasks under the present order, where the liveli- 
hood and the economic position of each individual are conditioned on 
the contribution he makes to the supposed welfare of his fellows. 

Efficiency. — What has been said concerning the volume of 
the factors available applies in considerable measure to their eifi- 
ciency. That feature of the present order which makes the share of 
each person dependent on his contribution as measured by others, 
stimulates him — assuming free competition — to raise the efficiency 
of the factor in his control as high as possible, 'in other words, to 
furnish efficient services. Finally, the system of private initiative 
probably promises to give greater efficiency in the utilization of the 
factors ; though it is doubtless true that governmental action can 
contribute much at this point, particularly by the discovery of better 



556 PRINCIPLES OF ECONOMICS [XLVII 

methods in industries where private initiative seems backward. In 
general, then, we may conclude that under the present order all the 
necessary conditions are fulfilled for securing a large volume of 
products. 

Objections. — The above verdict is concurred in by almost 
all economists. Yet perhaps a moment should be given to the oppos- 
ing contention of certain critics that the present order is not pro- 
ductively successful. In support of this idea they bring forward 
three considerations chiefly: the wastes of competition, the idleness 
of the parasitic classes, and the sacrifice of utility to value. 

The first of these points is easily answered. There are undoubt- 
edly zvastes in a system of free private initiative, — though their 
amount is grossly exaggerated, — but, in the opinion of the econ- 
omist, this so-called waste is merely the cost of a rarely eiJicient 
initiative, and a low cost at that. For all students of business or- 
ganization agree that the monopolistic and quasi-monopolistic busi- 
ness units are much less efficiently organized today than are the 
units exposed to free competition. 

Again, we cannot take more seriously the talk about the wasted 
productive capacities of the parasitic classes. To start with, their 
number is extremely small. A large proportion of the persons often 
designated as parasites are in fact performing functions essential 
to high productive efficiency. In the second place, it seems certain 
that, if they all were to become producers in the socialist sense, the 
amount they would add to the income of each person would be 
scarcely appreciable. 

Finally, the third objection of the socialist seems to economists 
to be a serious error. There is no doubt the possibility of a contra^- 
diction between utility and value. One who is seeking only to 
increase values may find himself in a position where he would better 
diminish output and sO' diminish utilities ; and, since the immediate 
return to producers is a value return (purchasing power in the form 
of money) rather than a utility one, it naturally follows that pro- 
ducers may at times gain most by reducing, or at least checking, 
the increase of utiHties. But the pursuit of such a policy is possible 
onlv through concert of action among producers; since values can 



XLVII] CRITIQUE OF PRODUCTION EFFICIENCY 557 

be increased by limiting output, only provided it is the total output 
which is thus limited, not merely that of some producers. But 
concert of action among producers is in contradiction to the very 
essence of the present order of which untrammeled private initiative 
is the dominant feature. Accordingly, it is quite illegitimate to 
represent this order as one in which producers will inevitably seek 
to increase values to the neglect, or even the destruction, of utilities. 
Increase of values is doubtless the natural goal of the producer as 
producer ; but, under a regime of free competition, the only path by 
which that goal, generally speaking, ca>n be attained is the increase 
of utilities} 

II 

The Present Order and Qualitative Excellence in Products 

The third requisite of an effective regulative mechanism for an 
economic order is fitness to insure that products should be of high 
quality as well as abundant in quantity. Is this requisite likely to 
be present in a regulative mechanism which consists of freely de- 
termined prices? At this point, it seems to me, our verdict cannot 
be so favorable. Doubtless the discriminating demands of buyers 
will secure high quality in some few products, through the natural 
competition of producers. But with the majority of products this 
rule will not apply. Unless government steps in to supplement the 
control effected by freely-determined prices, we almost everywhere 
meet with adulteration, poor materials, bad workmanship, etc. This 
might be remedied if buyers became more alert, better-informed, and 
more insistent with regard to their rights. But the likelihood of any 
such change is very remote. At many points buyers would find 
great difficulty fitting themselves to guard their interests even were 
they disposed to take the trouble ; at some others they are pretty 



^The last objection is perhaps given too little weight in view of the 
present trade-union policy of encouraging or requiring the limitation of 
output, — a policy which would probably be less pronounced under socialism 
than it is today. Doubtless the diminution or disappearance of the open 
approval of soldiering would tend to result in a considerable increase in out- 
put. On the whole, however, I believe that this would be more than offset 
in a socialist order by the diminution in motive for effort due to the much 
less rigid connection between wage received and service rendered. 



558 PRINCIPLES OF ECONOMICS [XLVII 

likely to be misled despite their efforts. Much evil may thus result 
both to individuals and the community ; so we cannot afford to leave 
regulation to the w^orking of spontaneous forces. It should be 
added, however, that the partiai failure of price control in this 
respect does not constitute a very serious defect in the present order, 
because the needed supplemental action of government is compara- 
tively easy to work out, as has been shown by the experience of the 
last sixty years in England. 

Ill 

The Present Order and Continuity of Production 

An economic order in which the regulative mechanism was effi- 
ciently operative for short periods only, — being every now and then 
completely thrown out of gear so that a highly disordered state of 
things ensued, — would be considered by everyone seriously de- 
fective, if not almost unendurable. An economic order to be really 
satisfactory, ought to show steadiness, regularity, dependableness, — 
ought to be free from all marked perturbations. Now in this respect, 
our system unfortunately does not work so well a\s we might desire. 
It is a familiar fact that production is subject to marked, almost 
violent, fluctuations, which naturally group themselves into the so- 
called industrial cycle; depression, recovery, increasing activity, 
normal activity, over-trading, crisis, collapse, depression, and so 
around again. The claim of the socialist that public initiative would 
almost, if not quite, eliminate this sort of thing is without doubt a 
fairly reasonable one. At all events, socialism would be certain to 
work better at this point than does the present system. The fact, 
however, is that the industrial cycle, in its serious forms, is a com- 
paratively modern disease, little more than a century old ; and much 
has already been done by our system to bring it under control. 
America, for reasons easy to trace, is still much subject to attack. 
But England, the original home of great panics, has had no serious 
crisis since 1866. In short, the leaders of industry are learning to 
control things sufficiently to safeguard this trouble or to palliate 
greatly its evils. Accordingly, while the present order cannot be 
cleared of blame, we should surely be unjustified at the present time 



XLVII] CRITIQUE OF PRODUCTION EFFICIENCY 559 

in pronouncing a final verdict against it on account of the defect 
in question. 

IV 

. Conclusion 

We set out upon this discussion by asking whether the systenx 
of regulating production through freely determined prices works out 
reasonably satisfactory results. What answer may we draw from 
the facts presented above? We may, and apparently are compelled 
to draw an affirmative answer — an aiUrmaiwe qualified, hut still an 
aMrmative. The results are certainly below the best conceivable. 
Nevertheless, while great improvements are needed, are possible, 
and ought to be effected, we must still hold that a verdict for the 
substantial soundness of the system is practically inevitable. We 
may add that a thoroughly humane despot with power to substitute 
any other system thus far proposed, might very probably — if he took 
all the facts into consideration — decide that the system now opera- 
tive was on the whole the very best one possible. 



CHAPTER XLVIII 

CRITIQUE OF CONSUMPTION 

In concluding our study, let us consider for a moment the satis- 
factoriness of the present order with respect to consumption. Con- 
sumption, sometimes treated as one of the main divisions of econom- 
ics, coordinate with production, exchange and distribution, has 
for various reasons been given little prominence in this volume. 
Nevertheless, our critique of the present order ought not to end 
without a brief comment on the way in which the price regulative 
feature affects consumption — the use which is made of wealth — 
and without some attempt to determine whether the result is satis- 
factory or the reverse. 

As respects the regulation of consumption, a satisfactory system 
needs to show three results chiefly: (i) Those natural resources 
which belong to society as a whole and to posterity must not be 
sacrificed to the selfish greed of the individual and the present; (2) 
the satisfaction of immediate wants must not absorb all our pro- 
ducing efforts to the neglect of that building of capital on which 
great productive efficiency depends; and (3) the best utilization of 
a stock of consumption products already existing should be assured. 

The first of these demands, we must admit at once, is very im- 
perfectly provided for in the present order. Under the free working 
of private initiative, the vast resources of a continent in lumber, 
coal, iron, etc., are being rapidly dissipated, and that in too large 
measure for the benefit of very small classes. Even the race itself 
has been threatened with serious deterioration through an unbridled 
use of liberty in the employment of women and children ; so that 
everywhere governmental interference has proved a necessity. All 
this is natural enough. When we are dealing with the interests of 
the remoter future, it is only within quite narrow limits that we can 
trust the forces which ordinarily prove efficient and safe regulators 

560 



XLVIII] CRITIQUE OF CONSUMPTION 561 

of economic action. The safeguarding of those interests is a duty 
which from its very nature rests upon the group, rather than the 
individual. Unfortunately, the group too rarely rises above the 
standpoint of those individuals who are economically most powerful 
and greedy; so that the duty of the group in this respect is too fre- 
quently neglected. Still it cannot be doubted that our only hope lies 
in this direction. Government must put great and rigid limitations 
on private initiative if the social patrimony is to be saved at all. 

As regards the second requisite of a system which properly regu- 
lates consumption — that it should not permit the satisfaction of 
immediate wants to absorb all our productive efforts to the neglect 
of capital-building — our present system can give an excellent account 
of itself, — a better account, probably, than could be given by any 
system depending on public initiative. Capital increases at an amaz- 
ing pace. The increase is doubtless not a little due to a feature of 
the system which is, in many respects, undesirable, the extreme 
inequality of incomes ; for this concentrating so much in the hands 
of a few makes the task of saving relatively easy. But there is 
another explanation. The present system powerfully stimulates 
accumulation in that it offers to those who save, great rewards, not 
so much in the shape of interest, as in the shape of those profits 
which may be obtained by the skillful use of a small initial sum. A 
further reason is found in the fact that the present system supplies 
highly convenient and efficient machinery for assisting the process 
of capital-building, in the shape of savings banks, insurance com- 
panies, bond exchanges, and the like. 

The third requisite — the best utilization of an already existing 
stock of consumption products — is easily met by the present system, 
save under quite exceptional circumstances. It belongs to the very 
nature of the laws of exchange to establish a price which adjusts 
demand to stock : reducing demand, if stock is deficient, by raising 
price; increasing demand, if stock is excessive, by lowering price. 
But here, again, we are confronted with the "rich-man-poor-man" 
objection which was brought forward against the present regulation 
of production. "Demand," it is said, "is doubtless adjusted to stock 
by being cut down through higher price; but unfortunately this 
means that the demand of the poor is reduced while that of the rich 



562 PRINCIPLES OF ECONOMICS [XLVIII 

remains at its old level." Now, there is doubtless some truth in 
this; the burden of curtailing consumption will often fall more on 
the poor than on the rich. Further, just as in production, circum- 
stances may arise where the discrepancy between the real magnitude 
of wants and their effective magnitude as expressed in price is so 
great that it becomes the duty of society to interfere with the auto- 
matic regulation and determine by authority the destination of its 
resources. Thus, when a famine of food, fuel, or other fundamental 
necessary threatens, it usually becomes the duty of government to 
intervene, even perhaps to the extent of taking upon itself the task 
of distributing these commodities. 

But, while extraordinary circumstances may arise which call for 
some other method of regulating consumption, the regulation by 
freely-determined price is on the whole fairly well adapted to most 
needs of human society. In the first place, it is easy to exaggerate 
the seriousness of the objection that in times of stock-deficiency, 
regulation through price throws the entire burden of curtailing con- 
sumption on the poor. Save with respect tO' a very few commodi- 
ties, indeed, the number of families who do not reduce consumption 
at all when price rises is very small, — so small that its continuance 
of the old scale cannot materially alter the result ; and here the 
government should, and usually does, step in and adjust the matter. 
In the second place the maintenance of a consumption policy which 
treats wants as having a social importance corresponding, not to 
their absolute magnitude, but rather to their apparent magnitude as 
expressed in the demand schedules of individuals, is a necessary 
complement to the system of distribution which is permitted to 
obtain. If incomes can legitimately be unequal, — and we have 
argued that they really must be unequal, — the needs of persons 
having unequal incomes, needs which are, absolutely considered, 
equal, must, after all, be treated as having unequal social impor- 
tances. For any other policy would destroy the inequality of in- 
comes which by hypothesis is necessary. 



APPENDIX 

EXPLANATORY NOTES 

Note I 

A somewhat different solution of the difficulty which in the text 
was met by the use of the concept "capital as capital" makes the 
essence of capital to reside in the fund of value embodied in the 
goods commonly called capital. This is real capital, pure capital, 
value capital. In contrast, the goods are concrete capital or goods 
capital or capital goods. 

Closely allied to the last distinction is one which contrasts money 
capital with real or goods capital. The former is the fund of 
money which is accumulated and then used to purchase the goods 
capital ; or, better, perhaps, which is conceived as having been put 
into the goods capital. This in turn suggests the distinction of 
invested capital and free capital, a distinction which the terms suffi- 
ciently explain. 

A distinction which is sometimes useful is that between formal 
or money capital and real or goods capital. The former is the fund 
of money or bank credit which the capitalist accumulates; while the 
latter consists of the actual goods, the engines, machines, coal, etc., 
which are elsewhere produced to be bought with the money capital. 
This distinction emphasizes the point that the things which we are 
really trying to get are the engines, machines, etc., the fund of money 
being only a go-between. The distinction must not, however, be 
taken too seriously. In a very important sense, the man who ac- 
cumulates the mere fund of money is responsible for the existence 
of the engines, etc. He it is who supplies the waiting power which 
makes possible this particular employment of our productive re- 
sources. 

Among older ways of distinguishing different forms of capital 
is one which contrasts fixed and circulating capital. The former is 

563 



564 PRINCIPLES OF ECONOMICS 

capital, like a tool or a machine, which gives off more than one 
service, while the latter is capital, such as the raw material used in 
making a wooden box or the coal burned in a steam engine, which 
does its part in a single use, gives off but one service. An interesting 
contrast is often drawn between specialised and general capital. 
Specialized capital is the kind which is fitted for one purpose only 
or for a very few purposes at most, for example, a planer, a copper 
steamer, or a printing press. Generalized capital on the other hand 
is something like coal, or pig iron, or most of all, money, which 
can be put to any one of many uses. 

Most people broaden the concept of capital as "products devoted 
to further production," making capital synonymous with income- 
getting goods, or all goods which serve their owner indirectly by 
supplying him with other goods. If we take the word in this sense, 
it is necessary to recognize a distinction between social capital and 
private or acquisitive capital. Social capital, which is virtually the 
same as that discussed in the foregoing paragraphs, produces other 
products, and is therefore income-giving even from the social point 
of view. But private, or acquisitive capital — for example, a gasoline 
launch rented to a summer resorter — does not increase the total 
volume of goods and so is not income-bearing from the social stand- 
point ; it yields an income to its owner only. 

Some writers include under the term capital all durable products, 
not only those devoted to production, but those, such as a dwelling 
house occupied by its owner, which are devoted to consumption 
as well. While the older usage is preferred by most authorities, 
there is much to be said in favor of the new. Indeed, the emphasis 
we have laid on "carrying" as the distinctive mark of capital as 
capital makes such an extension of the field to which the term 
is applied almost necessary. Durable goods are, as such, goods which 
give off their uses on the installment plan,^ that is, only a part of 
the services which they are capable of yielding can be enjoyed this 
year, 1921 ; we must wait for some of them till next year, for 
others till 1923, and so on. We can afford to resort to the use of 
such durable or instalment-service goods, e.g., brick houses instead 



* I sometimes call such goods "installment-service" goods. 



EXPLANATORY NOTES 565 

of wooden ones, only on condition that we have the necessary power 
to wait, to put into the house a great amount of productive resources 
which will in large measure yield its returns only after the lapse of 
a long period. 

A very natural extension of the term capital makes it to include 
such facilities and constructions as highways, canals, and bridges, 
which are usually maintained by the government. These things 
manifestly show the characteristics of being produced and devoted 
to further production. They are not, however, subject to private 
ownership, and so do not have a price ; hence they are not wealth in 
the usual sense, and, if capital is to be restricted to wealth in that 
sense these things are not capital. A natural compromise is to call 
them public capital. 

A less legitimate broadening of our term takes in the body of 
knowledge handed down from generation to generation which plays 
a very large part in economic production. In a sense, this has been 
and is being produced; and it is obviously being used to assist pro- 
duction. It is not, however, included among the things which possess 
exchange value, command a price. It is not, therefore, wealth ; and, 
not being wealth, it can be called capital only in a figurative way. It 
is sometimes designated social or public capital. 

Finally, it is sometimes convenient to speak of personal capital, 
in reference to the bodily or mental capacities and aptitudes of 
human beings. Most economists, however, consider such language 
figurative. Capital is only a particular kind of wealth, or wealth 
looked at in a particular way. But personal capacities are not wealth 
because, not being transferable, they have no exchange value; and if 
they are not wealth, they cannot be called capital in the economic 
sense of the term. 

Note 2 

In connection with the concept of "marginal product" discussed 
on page 131, a possible misunderstanding should be guarded against. 
The propriety of this designation for the addition to output conse- 
quent upon the addition of a unit of the changing factor is ques- 
tionable, but conforms to the common usage of current economic 



^66 PRINCIPLES OF ECONOMICS 

writing. In saying that, in combination ii, the marginal product 
of the L's is 15, that is, that the 2 L's added in that combination 
"produce" the 30 units of additional output, we do not mean that 
these 2 L's are alone responsible for bringing into existence those 
30 units of product. Such a contention would be absurd. When 
each of several factors must necessarily be present, if a given result 
is to be brought about, no one of them taken by itself can be 
physically or technically credited with the production of that result, 
or any assigned part of it. The whole 266 units of product resulting 
from combination ii are produced by the union of all the N's and 
all the L's entering into the combination. The 2 new L's could 
produce nothing if the 20 N's were not present. That is, the N's 
are just as necessary to the production of the additional 30 units 
of product as the additional L's; for there is no degree in necessity. 
In short, it cannot be too much emphasized that there is no possi- 
bility of isolating any portion of the product and saying that it was 
produced by any particular unit or units of any of the factors in any 
physical sense. 

What, then, do we mean by crediting a particular portion of the 
product to a particular pair of L's ? Simply this : that, in view of 
all the circumstances, it is reasonable to act as if those L's were 
alone responsible for the added units of product. These circum- 
stances may arise in several different ways. One of the best cases, 
perhaps, is met when a particular unit of some factor, say a piece of 
land, is superior to other units in actual use, which, however, are so 
numerous that they can be ignored in economic reckoning, — are in 
effect free goods. Since these units of the superabundant grade can 
be treated as non-economic factors, no part of their product, say 
20 bushels per acre, will be credited to them. The farmer as a 
laborer, or as a laborer and capitalist, will receive the whole product. 
But, if a man can afford to expend his efforts getting only the 20 
bushels yielded by the non-economic land, he can afford to pay some- 
thing for the control of a piece of land which would yield, with 
the same effort, 24 bushels. He can without impropriety affirm that 
such control would add 4 bushels to his output. He may, without 
being led into any practical error, conceive these 4 bushels to be the 
product of the land alone, though they are really no more the product 



EXPLANATORY NOTES 567 

of the land than the other 20 bushels ; and none of the 24 bushels 
are the product of the land any more than they are the product of 
the farmer. In a word, the real fact is this : from the economic 
standpoint, we act reasonably when we conceive that the land alone 
is responsible for the extra four bushels given off by this better 
grade of land. 

In the case just considered, we were enabled to ignore the share 
of the farmer in producing four bushels of the total product and 
to treat those four bushels as the special product of the land, because 
the maximum share going to the farmer was already determined as 
the product which he could get on the non-economic land. Substan- 
tially all that he could get beyond that he must regard as due to the 
special piece of land and, so doing, he can reasonably offer to pay 
to the owner for the privilege of using that piece of land anything 
less than four bushels of product. Another case wherein it is legiti- 
mate to ignore one of the factors and treat a particular part of the 
product as due exclusively to the other factor, arises when for any 
reason such other factor is conceived by the producer as fixed in 
amount. Thus we might suppose a farmer who was possessed of 
a piece of land which he could not or would not alienate, even in 
part, and to which he could not or would not make any addition, 
to be considering how much he could afford to pay a farm hand 
who was applying for a job. If, under such conditions, the laborer 
could add 200 bushels of wheat to the farmer's crop, the farmer 
could afford to treat his services as worth substantially 200 bushels 
of wheat, that is, he might reasonably act as if the laborer were 
alone the producer of these 200 bushels, though of course this 
would not be true in any literal sense — those 200 bushels would be, 
Hke all the other bushels, the joint product of the several factors 
involved. 

Note 3 

The discussion on page 295 brought out the point that 4 differ- 
ent prices of the demand and supply schedule play decisive roles 
in the immediate fixation of price. To avoid some rather persistent 
misunderstandings, it is perhaps desirable to note some differences 
in the processes by which these different limiting prices operate. 



568 PRINCIPLES OF ECONOMICS 

The marginal demand price as a check on the upward movement of 
actual price, and the marginal supply price as limiting the falling 
of price are mere indices of the presence of the real causes rather 
than themselves the forces accomplishing the results. Thus, when, 
in the silver schedule on page 281, the actual price refuses to rise 
above 55 cents lest it should exclude the 10,000 ounces of demand 
which came in only when price was as low as this, the fact really 
bringing about this result is the absence of that 10,000 ounces of 
demand at the higher figure, 56 cents, not the presence of that in- 
crement of demand at 55 cents. This is seen from the fact that, 
had there been no new demand at 54, or 53, or 52, or any lower 
price whatever, the price would still have come down to 55 cents, — 
even, in fact, to 54 cents. 

Analogous statements must be made with respect to the marginal 
supply price. As a limit to the falling of price from 55 to 54 cents, 
it is little more than an index of the presence of the real cause, 
that is, the failure of supply at the lower price, 54 cents. If no 
wheat whatever could be supplied at 55 cents, the price could not 
have gone down to 54 cents just the same, — in fact it could not 
have gone down even to 55. 

In contrast with this status of the marginal demand and marginal 
supply prices considered as upper and lower limits, respectively, 
the first extra-marginal demand and supply prices are themselves 
active causes in fixing the position of actual price. That price cannot 
go up to the first extra-marginal supply price just because it is that 
price, that is, because it of itself will let in too much supply. So the 
actual price cannot go down to the first extra-marginal demand price 
just because it is that price, that is, because it will of itself let in new 
increments of demand. 

Note 4 

As remarked on page 316, some economists hold that profits 
are not even at the present time an element in cost. Two of the 
considerations brought forward in support of this opinion will be 
briefly commented upon. 

First, it is sometimes remarked that, especially in the industries 
which involve much risk, for example, gold mining, the total ex- 



EXPLANATORY NOTES 569 

penditure — ^tlie expenditure over the whole industry — is probably 
much greater than the total return: some surpluses are gained, but 
more deficits are incurred. The answer to this is easy. That any- 
thing should be a cost does not require that every unit of that thing 
should be remunerated. The only question is this: Is the forth- 
coming of supply dependent to an appreciable extent on the covering 
of a particular item which is alleged to be a cost? Are there en- 
trepreneurs who will continue to supply commodities only on con- 
dition that they get from the business a return on their capital in 
excess of the interest which they could get simply by lending that 
capital ? and is the supply which is so dependent on the action of these 
entrepreneurs of sufficient volume to make its withdrawal from the 
market significant ? The correct answer is surely an affirmative one. 
Another way of maintaining the proposition that profit is not a 
true cost is to say that, although some entrepreneurs may earn 
profits, the marginal ones commonly do not ; and since it is marginal 
cost in which we are interested, this shuts profits out of costs alto- 
gether. The real ground for this contention is that there are always 
producers who are hardly able even to cover their cost of production, 
who go on year after year running more and more behind, gradually 
using up their capital; and because their cost is the greatest of all 
— so great as to deprive them of any profits — the objectors in ques- 
tion look on these producers as the real marginal ones. The answer 
to this objection is that the persons in question are not true marginal 
producers. The true marginal producer of any service or com- 
modity is the man who zvould first quit production should price 
fall; like the marginal seller (page 276), he is the producer whose 
presence is conditioned on the appearance of the marginal price. 
Now this plainly has no application to the class of persons described 
above. They are not brought into the market by the marginal 
price; they will not drop out of the market should the price fall 
still lower. They will continue to produce because they have no 
alternative. They are perhaps too old to change to some other 
employment, — hence keep on for the opportunity to employ them- 
selves, gradually consuming the little capital which they have in the 
business. 



570 PRINCIPLES OF ECONOMICS 

Note 5 

A special exception to the statement that rent is usually a part 
of the cost which determines the normal supply price may arise in 
this way. As indicated in the text, the reason we usually have to 
include rent is that the entrepreneur is driven to pay that rent 
because of the competition of persons who wish the use of the land 
for other purposes: that is, rent is what is called an opportunity 
cost. But cases arise in which the entrepreneur is compelled to pay 
a certain amount of rent for a particular piece of land, not because 
it is wanted in some other industry, — for some other purpose, — but 
only because it is wanted by other producers in the same industry. 
Thus, let us suppose that a given piece of land is- wanted for a par- 
ticular purpose in which its use would be worth $i,ooo a year ; while 
for the best of all other purposes its use would be worth only $800 
a year. In such a case, rent forms no part of the cost of the product, 
— the cost which determines the supply price. The tenant has to 
pay $1,000 for the right to use this piece, not because it would 
otherwise be devoted to raising some other product, but because, in 
being used to raise this product, it gives off a surplus of $1,000, and 
the competition of other producers' of this same product compels 
him to turn over that surplus to the landowner. When in doubt 
whether or not to consider rent in a particular case a cost, the simple 
test is this : Is the tenant driven to pay the rent he does pay 
through the competition of producers in other fields or through that 
of producers in his own field. In the former case, rent is a cost ; in 
the latter it is not. 

Note 6 

The untenable character of the doctrine that each product has 
its price fixed by its own marginal utility solely, is easily shown. On 
such a theory, the hypothetical case treated on page 389 would give 
the results represented in the accompanying diagram (Fig. i). The 
marginal significance of P^ being $120, would make its price $120, 
which would make the price of the 12 L's entering into it $120, 
which would make the price of i L $10; so the marginal significance 
of Po being $80, would make its price $80, which would make the 



EXPLANATORY NOTES 



571 



iL $ICK- 

iL $ 8^ 
iL $ 6^ 
iL $ 4<- 
iL $ 3^ 
iL $ 2^ 



12 L's $120-^ 

10 L's $ 8o« 

8 L's $ 48< 

6 L's $ 24^ 

4 L's $ I2< 

2 L's $ 4< 



I Pi $120^ 
iPo $ 80^ 
1P3 $ 48^ 

1P5 
iP« 



$ 24^ 
$ 12^ 
$ 4«- 



M 
M 
M 
M 

M 
M 



Pi $120 
P2 $ 80 
$ 48 
$ 24 
$ 12 
$ 4 



Figure i. 



price of the 10 L's entering into it $80, which would make the price 
of each L entering intO' it $8 ; and so on. But obviously, this result 
would be impossible; we should have in the same market at the 
same time, 6 different prices, $10, $8, $6, $4, $3, and $2, for the same 
commodity, i L. 

Note 7 

The theory as to the process of final price determination brought 
out on page 390 is in a general way that of the Austrian school. It 
may be represented in schematic form by the diagram in Figure 2. 



Stock] 



fSignificance 
/Schedule of 



Money Value of 
Cost Goods 




Figure 2. Austrian Theory 



In this diagram, L's are supposed to represent the single primary. 
factor or cost good, while Pi, Po, P3, etc., represent the different 
products arranged in the order of their marginal as well as their 



572 



PRINCIPLES OF ECONOMICS 



generic significance or value. Our stock of L's is supposed to be 
such that we can fairly satisfy our need for products ranging from 
Pi's down to Pg's, but no further. The utility schedules of all of 
these except Pg are supposed to be highly inelastic, so that when 
production is economically carried out the marginal utility of P^ 
stops at $120, that of P2 at $80, that of P3 at $48, and so on, as 
indicated in the third column of the diagram. At the top of the 
diagram, left and right, we have the two fundamental elements in 
the process of price determination : the stock or output of L's on 
the one hand, and the significance or utility schedule of products 
on the other. These are, so to speak, the sprirtgs from which flow 
all the forces that are in any way concerned in the process of price 
determination. The arrows leaving these two starting points, going 
around the main part of the diagram, and meeting at the lower right- 
hand corner bring out the point that, however complicated the 
processes by which the result would be reached, under our present 
hypothesis, the price-determining forces wviild come to a focus in 
the marginal significance of the marginal product. The remainder 
of the diagram shows that, after equilibrium has been reached, the 
reaction which is logically first among the reactions set up by the 
interaction of the stock of L's and the several significance schedules 
is the fixing of the (marginal significance of the marginal product, Pg. 
That, being finally fixed at $4, would cause the price of Pg to be 
$4, as indicated by the arrow going from right to left between these 
points. This price of $4 for Pg would, in turn, make the money 
value of the 2 L's contained in it $4, and, so, would make the price 
of I L $2. This price of $2 each for the marginal L's would now 
be communicated to all other L's, namely, to those L's which are 
used in the higher products. In consequence, the money value of 
that quantity of L's which is used in each of the several products 
would remain as many times $2 as the number of L's used in pro- 
ducing said product. Finally, the money value thus established for 
the L's contained in each product would be communicated to the 
products themselves ; that is, to P5, P^, P3, P2, and P^, as indicated by 
the five horizontal arrows running from left to right. As a result Pj 
would have a price of only $24, though its marginal utility or sig- 
nificance was $120; P, would have a price of only $20, though its 



EXPLANATORY NOTES 573 

.marginal significance was $80; and so on. That is, for all these 
supra-marginal products, cost, not utility, is the determining ele- 
ment, though more remotely the decisive thing is utility, only it is the 
utility of the marginal product, determining the price or value of 
the primary factor, and, through it, the prices of all supra-marginal 
products. 

Note 8 

In explaining the Austrian theory of final price determination, it 
is almost impossible to avoid letting in some misleading implications. 
Thus, it is almost impossible to avoid giving the impression that the 
marginal utility of Pg would be first determined independently of 
everything else; that this marginal utility would thereupon determine 
the price of Pg independently of everything else; that the price of 
Pg thus determined would then fix the price of L's devoted to its 
production independently of everything else; and so on. Now, it is 
surely quite impossible that anything like this should take place. 
No one of these things, whether the marginal utility of the marginal 
product or the price of any one of the various products or the price 
of L's, could be determined independently of the determination of 
every other one of them. The marginal significance of Pg could 
not be determined until the output of this product had been finally 
determined. In turn, the output of Pq could not be determined wntil 
the question of the number of L's available for this purpose had 
been determined. Again, the question of the L's available for pro- 
ducing Pg's could not be determined until it had been decided how 
many of the higher products, P^, Pg, P3, P4, were to be produced. 
Still, again, it could not finally be determined how many of these 
higher products were to be produced until it was known what price 
they were to have and, therefore, what demand there would be for 
them. But, since their price would be dependent on the price of the 
L's entering into them, and the price of L's would be dependent on 
the price of Pg, and the price of Pg would be dependent on its mar- 
ginal utility, we seem to be in a position where we are obliged to 
say that nothing could be determined until everything else had been 
determined. That is, we seem to be trying to break intO' a com- 
pletely closed circle. And this is of course true. Nothing could be 



574 



PRINCIPLES OF ECONOMICS 



finally determined until everything else had been determined. As in 
so many other fields, reaction as well as action is present and the 
result must be influenced by both. Nevertheless, it is legitimate to 
represent the real order of causation, when everything is finally 
settled, in the way we have done. When at last equilibrium would 
have been reached, the starting point of this causation — the point 
where the fundamental price-determining forces break into the circle 
— would he in the marginal significance of the product. 

Note 9 

The modification of our diagram made necessary by the intro- 
duction of the element of disutility is easily effected. As before 
there are two sources from which are derived the forces ultimately 
determining prices, and these appear at the top, one at the left, the 



Significance 
[Schedule of 

IP,.P2.P3.P4.P5.P6 




Marg. Disutility 
of L's 

-MDL's=$1.00 
-MDL's= 1.10 
-l\/IDL's= 1.20 
-MDL's= 1.35 y^ 
-MDL's= 1.50 IL=$2. 

IVID L's=^.00 
fDlsutl t fOem 



Money Value of 
Cost Goods 



12L's=$24.- 
10 L's = 20.- 
8L"s= 16.- 
6L's= 12.- 
4L's= 8.- 
-2 L's= 4.= 



Price of 
Products 

■IP, = $24. 
■IP2= 20. 




■IP3 = 
■1P,= 

-IP5 = 

:IP« = 



16. 
12. 



Marg. Significance 
of P's 

MSP, = $120 
MSP2 = 80 
MSP3 = 48 
MSP4= 24.* 

MSPg = 12 

♦: MSP«= 4 




Out-"] t fSig.] 
put U»l*-Jsch.K 
PesJ [PesJ 



Figure 3. Significance-Disutility Theory 



other at the right. The one at the left, however, is different from 
the old one. This time it is the disutility schedule of the single pri- 
mary factor^ L, or, what is the same thing, the supply schedule of 
that factor. Again, as in the former case, we have a process of 
causation which starts from the marginal utility or significance of 



EXPLANATORY NOTES 575 

the marginal product, moving thence to the price of that product, 
thence to the value of 2 L's, then to the price of i L. At this point, 
however, utility or significance finds itself obliged to recognize the 
influence of another force, the disutility of producing L's. For the 
existence of that disutility makes it impossible for equilibrium to 
be established until the price of each L is great enough to cover that 
disutility. Accordingly, we have this time in the lower left-hand 
corner a reaction between the disutility schedule of L's and the 
demand for them from which is determined the marginal disutility 
of supplying these L's, which in turn compels the price of i L to 
be what is needed to express this marginal disutility. That is, the 
price of I L is $2 not only when and because $2 is the marginal 
significance of the marginal product of L's, but also when and be- 
cause $2 is the marginal disutility of supplying L's. 

Note 10 

The point brought out in the text — that it is not the absolute mag- 
nitude of wants but rather the results conditioned upon their gratifi- 
cation which determines their social importances — seems obvious 
enough, yet is constantly disregarded by not a few writers. In con- 
sequence, it seems desirable to give it the emphasis derivable from 
diagrammatic presentation. In the accompanying figure, the open 
space to the right of the vertical line represents the field of social 
advantages or importances, while the enclosed space to the left of the 
vertical line represents the field of individual or private importances 
estimated as absolute magnitudes. The upper right-hand circle 
represents one-fifth of the social importance of the contribution of 
some person, Mr. A we will call him, — the whole of his contribution 
being assumed to have an importance represented by $5,000. The 
outer one of the two concentric circles at the left and above — the 
broken-line one — represents some want of the man contributing the 
$1,000 worth of service, which want the subject himself estimates at 
$1,000. The inner one of these two concentric circles — the con- 
tinuous-line one — represents the real or absolute magnitude of the 
want in question which is assumed to be only $100. The heavy line 
connecting the $1,000 circle of social importance with the $1,000 



576 PRINCIPLES OF ECONOMICS 

circle of individual importance as estimated by the individual im- 
mediately interested signifies that the getting of the $i,ooo worth of 
service, represented by the upper right-hand circle, is conditioned 
upon giving the man who contributes that service the volume of grati- 
fication represented by the outer one of the two concentric circles 
named. This brings out the relation among the wants and contribu- 
tions of Mr. A. Of the lower circles, the right-hand one shows the 



INDIVIDUAL 



GENERAL 




Figure 4. Social versus Individual Importance 

social importance of one-fifth of the service of a second person, Mr. 
B. The inner one of the two lower left-hand circles — ^the broken- 
line one — represents the estimate which B, in view of his money 
income, puts upon a certain want of his, while the absolute magni- 
tude of that want is represented by the larger outer circle — the 
continuous-line one — with the $1,000 mark. The heavy line con- 
necting the $100 circle of social advantage with the $100 circle of 
individual want — the dotted one — signifies that the forthcoming of 
said social advantage is conditioned on the satisfying of this want 



EXPLANATORY NOTES 577 

only so far as $100 will do it. Under these conditions, it is mani- 
fest that if A and B come into competition for the disposal of social 
resources, A's want which has an effective magnitude of $1,000, 
though having an absolute magnitude of only $100, will outweigh 
the want of B which has an effective magnitude of only $100 though 
its real or absolute magnitude is represented by $1,000. Now, to 
the unthinking, all this looks very unreasonable, not to say very 
wicked. The trifling want is treated as if it were the great one ; the 
great want as if it were the trifling one. But there is, broadly speak- 
ing, nothing in this view of the matter. The social importances in- 
volved are represented by the circles to the right of the line, — the 
circles located in the social field. It is on these that our eyes should 
be fixed. A's contribution has a social importance of $1,000; the 
supplying of that contribution is conditioned on the gratification of a 
want which A estimates at $1,000; said want, therefore, has a social 
importance of $1,000. B's contribution on the other hand, has a 
social importance of only $100 ; the supplying of that contribution is 
conditioned on the satisfying of a want which is formally expressed 
by only $100; said want, therefore, has a social importance of onlf 

$IQO. 



